Welcome to the Ingersoll Rand 2018 Q4 Earnings Conference Call. My name is Tiffany, and I will be your conference operator today. The call will begin in a few moments with the speaker remarks and the Q&A session. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. If you would like to ask a question during this time, simply press star, then one on your telephone keypad. If you would like to withdraw your question, press the pound key. We ask that you please limit yourself to one question and one follow-up. Thank you. Zac Nagle, Vice President of Investor Relations, you may begin your conference.
Thanks, operator. Good morning, and thank you for joining us for Ingersoll Rand's fourth quarter and full year 2018 earnings conference call. This call is being webcast on our website at ingersollrand.com, where you'll find the accompanying presentation. We are also recording and archiving this call on our website. Please go to Slide two. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of Federal Securities Law. Please see our SEC filings for a description of some of the factors that may cause our actual results to differ materially from anticipated results. This presentation also includes non-GAAP measures, which are explained in the financial tables attached to our news release. Joining me on today's call are Mike Lamach, Chairman and CEO, and Sue Carter, Senior Vice President and CFO.
With that, please go to Slide three and I'll turn the call over to Mike. Mike?
Thanks, Zac, and thanks to everyone for joining us on the call today. Please go to Slide three. Before discussing our fourth quarter and full year 2018 results, I'd like to begin with a brief review of the fundamental elements of our business strategy that underpin our financial performance and create value for our shareholders. First, our global business strategy is at the nexus of environmental sustainability and impact. The world is continuing to urbanize while becoming warmer and more resource-constrained as time passes. We excel at reducing the energy intensity in buildings and industrial processes, reducing greenhouse gas emissions, reducing waste of food and other perishable goods, and we excel in our ability to generate productivity for our customers, all enabled by technology. Our business portfolio creates a platform for the company to consistently grow above average global economic conditions, aided by the strong secular tailwinds I've outlined.
Second, our business operating system is designed to excel at consistently delivering strong top-line growth, incremental margins, and free cash flow. Lastly, over the years, we've built an experienced management team and a high-performance winning culture that makes our performance sustainable. When combined with our dynamic capital allocation strategy, we have a differentiated business model that drives strong shareholder returns over the long term. Turning to Slide four. Focused and consistent execution of our business strategy enabled us to deliver top-tier financial performance in 2018. We delivered top-quartile organic bookings and revenue growth in each quarter and closed out full year 2018 with 13% organic bookings growth and 9% organic revenue growth for the enterprise. Adjusted earnings per share growth was also top quartile, up 24% for the year and up 29% in quarter four.
Despite persistent material and other inflation and tariff-related headwinds, our team successfully developed and delivered pricing and productivity actions that enabled us to effectively manage these costs and drive improved leverage and solid margin expansion throughout the year. Importantly, at the end of quarter two, we set out to achieve significantly improved leverage of 25% in the second half of 2018. The team delivered against that objective, while at the same time delivering record organic bookings and record revenues. Additionally, we achieved 10 basis points positive price cost for full year 2018, with 60 basis points of enterprise adjusted operating margin expansion. While at the same time continuing our healthy pace of incremental business investment, which is core to our ongoing differentiated operational and financial performance. Free cash flow for the year was 82% of net income, which lagged our 100% conversion target.
The largest component of the shortfall is related to funding working capital above normal levels through the end of the year in order to meet growing customer demand for our products and services. We also funded additional CapEx for high ROI projects beyond what we expected when we entered the fourth quarter. We've delivered an average of 110% free cash flow to net income conversion over the past four years, and we expect to return greater than 100% in 2019. Lastly, in 2018, we also continued to execute our balanced capital deployment strategy. After investing in the business, including $366 million in capital expenditures, largely related to footprint optimization and plant consolidation, we deployed approximately $1.7 billion between dividends, share repurchases, and mergers and acquisitions. Turning to Slide five. Our performance against our initial guidance expectations was strong, with exception of free cash flow, which I discussed earlier.
We significantly beat on both the top and bottom lines and delivered strong margin expansion while managing inflation and tariff-related headwinds and making healthy investments in the business. Turning to Slide six. Focused execution of our business strategy is delivering differentiated results in the marketplace and for shareholders. We will maintain this focus going forward. Looking at 2019, we see the fundamental ingredients for another strong year. First, our end markets generally remain healthy, and I'll address that in more detail on the next couple slides. Second, we're entering 2019 with record backlog in multiple business units after achieving exceptional bookings throughout 2018. This provides us with improved visibility into what to expect for 2019 revenues relative to where we'd have traditionally been at this stage in the year. Third, in 2018, we demonstrated our ability to effectively manage inflationary and tariff-related headwinds through pricing and productivity.
Combined with higher expected volumes, we expect this to enable us to continue to deliver solid leverage, improving margins and strong EPS growth in 2019 as we did in 2018. For 2019, we're expecting free cash flow to exceed adjusted net income. We will continue to execute a dynamic capital allocation strategy that deploys capital where it earns the best returns. This includes organic investments, dividends, mergers and acquisitions, and share repurchases. On the M&A side, we have an active pipeline of attractive opportunities that would be a strong fit with our core business strategy. If or when these become actionable and affordable, we're in a strong position to execute any transactions. We also continue to see value in our own shares, which are trading well below calculated intrinsic value.
Lastly, based on our performance in 2018 and our guidance for 2019, we're firmly outpacing the glide path to achieving our 2020 Investor Day revenue growth, EPS, and free cash flow guidance that we laid out during our mid-year 2017 Investor Day. Given the tremendous amount of inflation and tariffs the industry has endured over the last two years, we're moving along that glide path a bit differently than what we expected in 2017, but we're well ahead of the curve nonetheless. Turning to slide seven. Our end markets continued to show strength throughout the fourth quarter, and 2019 appears to be shaping up as another solid year. In commercial HVAC, the markets remained strong in virtually all geographies, and we delivered strong bookings growth and revenue growth across the product portfolio.
Europe has shown mixed economic signals over the past few months, but HVAC activity remains healthy there as well. China had a solid quarter in HVAC, with good growth in both equipment and services. Our direct sales strategy in China continues to progress well against our expectations, and we're making good inroads in a number of verticals, including infrastructure, which has been a key focus for us and continues to be one of the strongest verticals. The situation remains fluid with trade war uncertainty, but at this point in the year, we're still expecting to see modest market growth and market share expansion opportunities in China. Outside of China, the Asian markets are mixed. In total, our global outlook for the commercial HVAC market continues to be positive, with low double digit to mid single digit market growth expected. Turning to residential.
Quarter four was another very strong quarter for us with continued share gains. Growth was primarily driven by replacement demand, and we expect the majority of the market growth to come from the replacement market in 2019 as well. This plays well into our business mix, which is about 85% replacement. Economic indicators have softened modestly but are still healthy and supportive of growth for the year. Turning to slide eight. Our transport business continues to be a globally diversified and resilient business with good growth opportunities across multiple areas. In 2018, we saw exceptional order growth for North American trailers and auxiliary power units, and we've built a healthy backlog as a result. In 2019, our strong backlog position for these businesses gives us solid visibility into revenue growth for the year as we work to convert this backlog to revenue over time.
The European transport markets are mixed, with trailer a bit weaker and truck a bit stronger as Brexit uncertainty is impacting these markets. We think additional clarity around this topic would be a positive catalyst. Overall, we're expecting low single digit to mid single digit market growth for transport refrigeration in 2019. Our Compression Technologies business had good growth globally in the fourth quarter, with North America and Europe healthy. We continue to see trade war uncertainty impacting projects in China. Global services growth continued to outpace equipment growth in the fourth quarter, which is a positive and is well supported by multiple service initiatives focused on increasing attachment rates of services to equipment and increasing our share of wallet of total services provided within accounts.
All things considered, we expect to see low single digit, mid single digit growth in the Compression Technologies market in 2019, with China being the main area to watch closely. Small electric vehicle growth continues to be powered primarily by our consumer and utility businesses. We expect to see healthy growth in 2019. Our industrial products businesses, including fluid management, tools, and material handling markets, remain healthy, and we expect to see continued solid growth in these businesses in 2019. Now I'd like to turn it over to Sue to provide more details on the quarter and discuss our 2019 guidance. Sue?
Thank you, Mike. Please go to slide number nine. I'll begin with a summary of a few main points to take away from today's call. As Mike discussed, we drove solid operating and financial results in the fourth quarter with adjusted earnings per share of $1.32, an increase of 29% versus the year ago period. Our earnings growth in Q4 closed out a strong year in which we delivered adjusted earnings per share growth in excess of 20% in each quarter. Organic bookings and revenue growth was strong in both our climate and industrial segments. In our industrial segment, we delivered 6% organic bookings and revenue growth. Organic bookings growth was healthy in the fourth quarter, despite a difficult comparison of 12% organic growth in the fourth quarter of 2017.
On the climate side, organic bookings were exceptional, up 20%, including a large commercial HVAC order that will provide revenue over the next three to four years. Excluding this order, organic bookings growth was still outstanding, up 13%. These exceptional organic growth rates accelerated despite difficult comparisons with very strong growth rates of 7% in the fourth quarter of 2017 and 10% in the fourth quarter of 2016. Organic revenue growth was also exceptional, up 9%, and was broad-based across all of our climate businesses and across both equipment and services. As Mike discussed, free cash flow was 82% of adjusted net income, primarily due to funding higher working capital to support our exceptional bookings and revenue growth and funding additional CapEx for strong projects in the fourth quarter.
We continue to drive high-quality earnings and expect to deliver free cash flow in excess of 100% of adjusted net income in 2019. Leveraging our business operating system for operational excellence across the enterprise, we continued to manage direct material, tariff-related, and other inflationary headwinds in the quarter. During Q4, we delivered our targeted 25% operating leverage and expanded adjusted operating margins 90 basis points. For the year, our 60 basis point adjusted operating margin improvement was towards the higher end initial guidance. Importantly, we also delivered on our dynamic capital allocation strategy in 2018. We deployed $480 million in dividends and increased the dividend 18% during the year, consistent with our commitment to maintaining a strong and growing dividend over the long term. We deployed $900 million on share buybacks as the shares continued to trade below our calculated intrinsic value.
We also deployed $285 million on strategic mergers and acquisitions in 2018, the majority of which was committed to spend in 2017. Looking forward, we expect to consistently deploy 100% of excess cash over time. Please go to slide number 10. As we discussed on the previous slide, the fourth quarter was highlighted by continued strong organic bookings and revenue growth in both of our segments, as indicated by the positive signs on the chart. The one minus sign on the chart was a revenue decline in commercial HVAC in the Middle East, where orders and accompanying revenues can be lumpy. Last quarter, we highlighted that there were a couple of large orders in the third quarter of 2017.
These orders shipped in the fourth quarter of 2017, creating a difficult comparison for us in the fourth quarter of 2018. European HVAC orders and revenues showed continued strength in the quarter. Please go to slide number 11. We delivered organic revenue growth of 8%, adjusted operating margin improvement of 90 basis points, and adjusted earnings per share growth of 29%. Strong gains in volume from ongoing investments in new products, channel, and system controls are delivering results in virtually every business and geography where we compete. Consistent, disciplined focus on productivity and pricing actions enabled us to effectively manage inflation and tariff-related headwinds and drive margin expansion across the enterprise. Please go to slide number 12. The focused execution of our business strategy, underpinned by our business operating system, enabled us to drive solid year-over-year earnings per share growth in the quarter.
Our climate segment delivered another strong quarter of operating income growth. Our industrial segment delivered solid results with our Compression Technologies business, in particular, levering over 40% in the quarter. Corporate productivity initiatives drove $0.05 of earnings per share growth year-over-year. Below the operating income line, other expenses related to legacy legal matters negatively impacted results by approximately $0.04. All in, we delivered 29% earnings per share growth with strong results across the enterprise. Please go to slide number 13. Strong execution drove 90 basis points of adjusted operating margin improvement in the quarter. Price versus material inflation was positive by 40 basis points in the quarter and positive by 10 basis points for the full year, reflecting strong pricing efficiency and a return to more normal price cost despite the extraordinary inflation we were up against in 2018.
Productivity versus other inflation was notably stronger in Q4, improving margins by 30 basis points. For the full year, productivity fully offset other inflation. We also continued to reinvest heavily in our business with incremental Q4 investments of approximately 60 basis points, pretty evenly weighted between operating expense reduction projects to drive further productivity, footprint optimization, plant consolidation projects for commercial HVAC and Compression Technologies, and new product development and information technology investments. All of these investments work in concert to make Ingersoll Rand a stronger and more resilient business. Please go to slide 14. Our climate segment delivered another strong quarter with 9% organic revenue growth and adjusted operating margin expansion of 40 basis points. Consistent with our expectations, results were strong across the segment. Please go to slide 15.
Our industrial business also delivered strong results with 6% organic revenue growth and 40 basis points of adjusted operating margin expansion with Compression Technologies leverage up more than 40%. Outside of Compression Technologies, the overall industrial segment leverage was negatively impacted by discrete accrual adjustments and a legal settlement totaling approximately $5 million. We expect industrial segment leverage will be strong moving into 2019, as it has been over the past several quarters. Please go to slide 16. In 2018, we executed a dynamic and balanced capital allocation plan, deploying capital where it earns the highest returns for our shareholders. We maintained a healthy level of business investments in high ROI projects to help customers solve their most complex challenges. These investments helped drive our strong growth in both segments during 2018.
Beyond that, we invested $366 million in CapEx, largely on footprint optimization and cost out programs, which build a stronger, more resilient Ingersoll Rand. We maintained a strong balance sheet that provides us with good optionality as our markets evolve. We executed against our longstanding commitment to a reliable, strong and growing dividend. During 2018, we raised the dividend 18%. Additionally, we deployed approximately $900 million on share repurchases as the shares continued to trade below intrinsic value. As we look forward to 2019, we remain committed to a dynamic capital allocation strategy that consistently deploys excess cash to the best return on investment opportunities. We're enthusiastic about the future and the opportunities ahead to deploy excess capital to the best ROI investments, whether that be investment in the business, raising the dividend, repurchasing shares, or making value-accretive strategic acquisitions. Please go to slide 18.
I'll spend a few minutes walking you through the details of our 2019 guidance. Given the market backdrop Mike outlined earlier, we expect total reported revenues to be up 4% to 5% in 2019, with the climate segment growing slightly faster than industrial. The difference between our reported and organic revenue contemplates about one percentage point of negative foreign exchange impact year-over-year. For the enterprise, we delivered solid leverage and margin expansion in the back half of 2018. In 2019, we expect further margin expansion in each segment and enterprise adjusted operating margin expansion of between 30 and 80 basis points. Please go to slide 19. We expect continuing adjusted EPS for 2019 to be in the range of $6.15 to $6.35, excluding about $0.25 of restructuring.
We've modeled approximately $500 million in share repurchases into our guidance, which translates into approximately 244 million diluted shares for 2019. As I outlined earlier, we're committed to a dynamic and balanced capital allocation strategy that consistently deploys excess cash over time. Net, the actual allocation of excess cash will depend on where we see the highest ROI opportunities over the coming quarters. We're targeting free cash flow to be greater than 100% of net income. The adjusted effective tax rate is estimated to be between 21%-22%. For your modeling purposes, we also offer the following guidance. Corporate expenses are expected to be approximately $250 million. Capital expenditures are expected to be approximately $300 million, primarily driven by footprint optimization, factory consolidation, and new product development initiatives.
Below operating income, we estimate interest expense to be approximately $200 million, reflecting the debt refinancing we did in early 2018. Additionally, we estimate that pension-related expenses that are classified within the other income and expense line will be approximately $40 million for 2019. We do not plan other income or expense line items outside of pension. These items are truly other and not estimable in advance. Now I'd like to cover two topics of interest with you. Please go to slide 21. It's hard to keep track of what's happening with tariffs relative to what's in and what's out of guidance, so we thought it might be useful if we laid out the assumptions that we're using.
The guidance I just laid out includes the known direct and indirect impacts we expect from the Section 232 tariffs, the Section 301 tariffs, including lists one, two and three , which is the full $200 billion, and the expected China retaliatory tariffs. Relative to the Section 301 tariffs, we have included the planned step up from 10%-25% on March 1st of 2019 at the conclusion of the 90-day negotiation period. As we've said a number of times during this call, we expect to be able to effectively manage the inflationary and tariff-related impacts in 2019 as we manage these types of costs in 2018. To be clear, however, if the step up from 10% and 25% does not occur, you should not anticipate we'll see a windfall gain. We will implement the pricing actions necessary to cover the actual inflation we see.
The next topic, which is on the same slide, is on 2019 restructuring costs. We thought it would be helpful to provide a little extra content beyond what we included in the main presentation. The restructuring we're doing in 2019 is largely aimed at proactively taking steps to build stronger, more resilient businesses in both our climate and industrial segments. Of the estimated $0.25 of restructuring in 2019, more than 80% relates to our ongoing footprint optimization and plant consolidation efforts. Each optimization project is expected to reduce our fixed cost base and improve operational efficiencies, which benefits us no matter the economic conditions we encounter going forward. With that, I'll turn the call back to Mike.
Thanks, Sue. Please go to slide 22. We believe the company is extremely well-positioned to deliver strong shareholder returns over the next several years. Our 2018 financial results bolstered our confidence. We'll be the first to recognize that 2018 was by no means a perfect year, that we have room for further improvement. However, our ability to solve complex problems and overcome escalating headwinds to drive continuous improvement in our results through 2018 is encouraging and gives us confidence our business operating system and high-performing teams are prepared to successfully navigate the evolving landscape ahead. I want to extend my full appreciation to our talented people throughout the world that are committed to delivering excellent results for our customers and shareholders. Our strategy is firmly tied to attractive end markets that are healthy and growing profitably.
Our products and services portfolio is at the nexus of global energy efficiency and sustainability mega trends, which provides a tailwind for growth above average economic conditions over the long term. Unless you believe the world is getting less populated, cooler, and less resource-constrained, these secular mega trends will continue to create growth opportunities for Ingersoll Rand. Successful execution of this strategy enabled us to deliver exceptional bookings and profitable revenue growth in every quarter of 2018. We have an experienced management team and a high-performing team culture that incorporates operational excellence into everything we do. Our business operating system and our culture are a differentiated and sustainable competitive advantage. Lastly, our business model generates powerful cash flow, and we are committed to dynamic deployment of capital. We have a strong track record of generating free cash flow and deploying excess cash to shareholders over the years.
With that, Sue and I will be happy to take your questions. Operator?
At this time, if you would like to ask a question, please press star followed by one on your telephone keypad. Your first question comes from the line of Scott Davis with Melius Research. Your line is open.
Hi. Good morning, guys.
Morning, Scott.
Morning.
Boy, there's not much to pick on in this quarter at all, you made a couple comments I just wanted to dig into a little bit, in particular really about the push to the right on some of the commercial projects in China. Is it the opinion of your local guys that this is just more of a delay or maybe something a little bit more tied to the tariff outcome? Or what's really the color behind some of those comments?
You have to separate the businesses a bit, Scott. Take HVAC, where we saw, again, really strong bookings growth and continued momentum there in services as well. In those markets, I think it's less susceptible, particularly on the government commercial side involving infrastructure, institutional work, that there's more of a bias toward reducing greenhouse gas emissions. As I've said, hopefully a thousand times, if you're going to go attack the greenhouse gas emissions problem anywhere, you're going to hit HVAC, whether it's stationary or transport first, because it's 15%-25% of most economies' global greenhouse gas emissions. I don't think that China lets its foot off the gas around codes, compliance, and regulations that would improve air and water quality. That being said, you look at the industrial business, here, I think the trends are largely the same.
Interestingly, we saw good growth in some of the smaller compressors, some of our contact-cooled rotary, and certainly in our rotary compressor lineup in general, but certainly oil-free would have been part of that. That continues. What I get mostly from our suppliers and from our customers that are in China exporting outside of China, particularly to the U.S., is they are waiting to see. However, some of them are moving more rapidly to put incremental capacity in Asia outside of China. Vietnam is a favorite spot for that right now. I think that you're already seeing sort of actions taken by Chinese companies that export. I think you'll continue to see that going forward. By the way, that's positive, Scott, for us, because it doesn't matter sort of where they set up shop, we're going to be able to support them.
Yeah. That's going to be my natural follow-on, is that are you a net winner or a net loser? You have critical mass in China, and some of those other regions, maybe you don't, or do you?
Yeah, we have strong footprint throughout Asia. You really can't get to a part of Asia where we don't have a team on the ground, sufficient capacity to supply it. It would be good so long as that capacity is unlocked somewhere we would have opportunity.
Okay. I'm going to pass it on. Thank you, guys.
Thank you, Scott.
Your next question comes from the line of Steve Tusa with J.P. Morgan. Your line is open.
Hey, guys. Good morning.
Hey, Steve.
Morning.
Can we just dig into the bridge, the margin bridge a little bit? What was exactly in investment and other? Could you maybe just give some color on how you see kind of that price material number kind of trending? I think you said no windfall if the tariff doesn't go through, but like you're already 40 basis points ahead of the game here, definitely better than we expected in Q4. I would think that can get better on its own ex tariffs next year. Maybe just give a little bit of color on how you see both of those parts of the bridge broadly trending into 2019 guidance.
Yes, Steve, when you say walk through the bridge, are you thinking about the 2019 bridge or the 2018 fourth quarter bridge?
Yeah, I'm just in the context of what happened in the fourth quarter, I guess, 2019. Maybe just explain the 60 basis points, what was in there in the Q4, and then, moving beyond to 2019, how you'd see that play out.
Yeah, I would start and I'll let Sue finish. Price over material inflation was something that we had hoped to get back to, say, zero for the full year. We got to 10 basis points, roughly at our expectations there. That worked out, materialized as we hoped that it would. One of the questions going into 2019 then is why is there not more positive price versus cost, given some of the carryover? What I would say there is you got to remember that the Section 232 tariffs were implemented in April and May, and the Section 301 were implemented in October. The first half still sees headwinds from tariffs that didn't exist last year at the same time. We also would see commodity inflation in quarter one and quarter two still.
See steel as being the largest, copper as being next. Of course, the Tier 2 knock-on effect containing these metals would be inflationary in the first half of 2018. By quarter two, you start to lap the majority of price from 2018. Materials begin to get perhaps deflationary, tariffs remain in our model, so you might see a wider spread in Q3 or Q4. It's pretty early to call how all that looks. Our plan is laid out as I've just expressed in that regard. Sue, what about any of the bridge items?
Yeah. If you think about, Steve, your question on investment in the fourth quarter and going into 2019, the investments in the fourth quarter were as we had planned them throughout 2018, they're primarily investments in operational excellence, in new product development, in some of the footprint optimization that we were doing. Those actually do carry over, and we continue to invest in the business as part of our capital allocation strategy in 2019. Nothing terribly unusual or unexpected as you think about either the fourth quarter of 2018 or where we're going in 2019. It's that overall strategy of really providing for projects that make us operationally better, increase productivity, and allow us to manage the business.
Yeah. Sue, I'd probably add one point, which is when you think about the productivity over a long period of time, creating higher utilization and really opening up new capacities, we've taken the decision over the years to slowly as projects emerge and you can consolidate, reduce footprint, we've done that. You've seen in 2018 and 2019 a more aggressive view toward that. There was a step up in 2018, not quite as high a step up in 2019. That's, at this point, sort of the last of what we see as the larger projects would entail for us, and we want to be clear that we're not thinking about a recession in 2019. We wanted to get really in front of that final large restructuring now.
Just really in the event that something would happen into the future around a recession, we're just going to be that much more resilient around that. That's another part of what the investments involved through 2018 and certainly in the fourth quarter of 2018.
Historically, that investment number is kind of a modest negative. Is that what we should think about for 2019? A more modest negative?
The total investment number on the bridge itself is always run around 40, 50 basis points.
Yeah.
That's exactly what-
Okay
we would be modeling in 2019.
Yep. Got it. One last one. Normal seasonality, first half to second half next year, how should we think about seasonality for 1Q and next year?
Steve, I love you're adapting your question because I was expecting the one about quarter one. Let me answer that one actually first, because I appreciate you're taking a longer view on that. Quarter one is usually the part that I think creates the most confusion around investors. Historically, if you look at the three-year average, we've been around 12.4%. If you go to a long-term average, it's been around 11.1%. I think that when you think about the seasonality for us, it largely comes into the first quarter, and for models that are between 11 and 12.5%, you're kind of in a safe range. If you're north of that, you're probably figuring out something that we don't know about. That's how I would kind of give you some thoughts around quarter one. The rest of the year sort of works itself out.
I don't think there's been that many situations where there's been confusion around just the back half of the year or even quarter two.
Wow, you gave me more than I thought I was going to get. I appreciate that. Thanks, guys.
Thank you.
Your next question comes from the line of Julian Mitchell with Barclays. Your line is open.
Hi, good morning. Maybe a first question around the free cash flow. Within that step up of conversion in 2019, I think you're guiding for CapEx to drop almost 20%, but you're still guiding for operating cash flow to grow about 25%, so double the EBIT growth guide. Maybe just spell out, is that mostly coming from receivables, for example, and how quickly through the year do you think we see that improvement, given your cash flow tends to be pretty seasonal?
Yeah, Julian, it should be a good story for us in 2019. We really do expect to have greater than 100% of net income in free cash flow. As you take apart those pieces. Let's talk about CapEx for a second with the approximately $300 million guide for 2019. That is lower than 2018. That was $366 million, and there's a couple of components to that. We made a couple of decisions on projects in 2018. We had some carryover. We had a warehouse facility where we were doing a warehouse consolidation, absolutely a good project. We made a decision to lease versus buy. long story-
Other way around, own versus lease.
Own versus lease. Sorry, Mike. As you think about the CapEx, it sort of normalizes back into our more 1%-2% of revenues range in 2019. That's helpful. As you think about working capital, working capital isn't going to change from an overall strategy viewpoint, which is that you're always going to be looking to balance out your customer terms and your supplier terms. DSO and DPO, always looking to balance those out. On inventory, you're looking to make sure that you have enough product to meet the demand that we have, which has, of course, been quite strong. At the same time, meet your on-time customer delivery.
What I would expect to see in the free cash flow guide in 2019 is that as we move through 2019, that the working capital as a percentage of revenue is also going to normalize back more into our 3%-4% range of the long-term guide. We're moving back into more of the longer-term metrics in the 2019 statistics, that's what gives us the additional bump in free cash flow for next year.
Great. Thank you. Then my second question, maybe a bit more color on what you're seeing in Europe overall. I think you'd mentioned that in Thermo King, you have some specific watch items which are understandable. Anything interesting changing in Trane or on the industrial side in terms of customer spending appetites and so forth? Maybe split anything on Western Europe versus the Middle East.
We've had a very strong HVAC year in quarter four in Europe. That continues. Again, here, this is this bifurcation between economies very focused on energy efficiency, greenhouse gas emissions, and making the regulatory changes to make that happen. The growth rates there are outstanding. Then you're looking at sort of the industrial side of Europe is slower than that, of course, as you're really, I think, factoring in sort of a sloppier Brexit. I think the economy is a little bit in a slower mode there. All in all, it's certainly not bad in industrial in Europe for us, and it's been great in HVAC. Middle East has just been choppier with the way orders come in there. Generally, you're talking about district cooling plants that are extremely large.
Whether they build them or not, or modify them or not, can make a difference quarter to quarter. I think the environment there is good for us. It's just a matter of the lumpiness in orders. We're relatively optimistic on Europe and certainly the Middle East as well. In terms of transport refrigeration in Europe, it's a little bit mixed. You've got a slowdown in Western Europe. You've got continued growth in Eastern Europe. You see a little slower European trailer market, and you see a little stronger European truck market. Again, I think this is just really working through some of the general economic concerns, largely Brexit. Clarity on Brexit, frankly, sort of a good outcome there. Clarity would be sort of a baseline outcome, I think is a positive for the market and for our businesses.
Understood. Thank you.
Thank you.
Your next question comes from the line of Nigel Coe with Wolfe Research. Your line is open.
Thanks. Good morning, guys.
Hi, Nigel.
Morning.
Gee, Mike, it sounds like you had that Q1 answer prepared.
I didn't want to disappoint Steve on that one. I got it.
Yeah, 12.4%. That was pretty specific. The large commercial order, I don't think I've ever seen you call out an order of that size and such long cycle. Maybe just a bit more color in terms of that and how that progresses. What's the market like for that kind of size of order? I mean, are you seeing other opportunities of that scale out there?
Yeah, we actually had one in 2016. I wish we would've called it out in 2016 because that created a little bit of confusion in 2017 when it lapped. I think it was in the $120 million range. This one's closer to $200 million. I think that we're going to see more of these, where it's a holistic approach toward reducing energy use in facilities, campuses, buildings, reducing the energy intensity, maybe even getting some grid flexibility, moving toward alternative power. We're seeing more of that. For us, we're seeing that it involves design, equipment, lots of controls, service, monitoring over time, and then some subcontracts that would go along with that. They're lumpy. I've been probably talking about this for three or four quarters.
That's one of the larger projects that we thought would close. I think these things will get spotted in over time. This particular project will last about 40 months. It'll burn revenue in a pretty linear fashion. We like that. We like the, again, the resiliency over four years of having a nice base of business to build on. The margins are pretty good. It shouldn't really affect what we expect to be good leverage for the business going forward.
Okay. That's really helpful. I think you mentioned your shares below intrinsic value for, I think, three or four times during the call. You also mentioned M&A opportunities. I'm actually wondering, given that you consider your share price too cheap right now, is the needle for incremental dollars still towards buybacks? Do you see opportunities out there to deploy M&A more creatively than share buybacks? Any comments there would be helpful.
Yeah, it's both, Nigel. You can expect that it would be both for us, it's really looking at the actionability, affordability, the ROICs of the M&As out there based on what we think we could do that for, comparing that toward intrinsic value. Of course, the benefit on the acquisition is building a compounding base of cash over time, particularly if they're good businesses that strategically fit the core of the company. That's the focus. As you know, we're not going to let cash sit around for long, we're going to deploy it somewhere, that's what certainly happened in the fourth quarter, where you saw us really step up the buyback in the fourth quarter. Balance sheet's in great shape, plenty of capacity there and flexibility to work with the balance sheet going forward.
Okay. Thanks, Mike.
Nigel.
Your next question comes from the line of Joe Ritchie with Goldman Sachs. Your line is open.
Thanks. Good morning, everyone.
Morning, Joe.
Morning.
Just to clarify a couple points on the cash flows, Sue. Obviously nice step-up expected in 2019. You guys are expecting roughly 40% growth. Get the CapEx point. It seems like the delta is half of it seems to be coming from working capital improvement, half of it coming from earnings growth or EBIT growth, core EBIT growth. On the working capital side, are you assuming the turns get a turn better, or how should we be thinking about that working capital piece?
Yeah. If I think about, Joe, I go back a little bit with the working capital as a percentage of revenue, where we would have called that at year-end would've been probably 3.4%, 3.5%, somewhere right in the middle of our 3%-4% range, and it ended up at 4.3%. You actually do get, to your point, about a full point of that coming out of there. Again, it is a process where it is not just making a decision of whether you're going to have inventory there or not. There's a series of levers that happen as you see the demand forecast, as you plan what's going to happen in the factories, and you plan how you're going to actually efficiently manage those factories going through time to meet that on-time customer delivery. Your point is the right one.
The inventory will probably come down over time, and everything else remains balanced, but it does go back into that 3% - 4% of revenue range, which is what gives you the uplift.
Of course, Joe, we deliver really outsized cash in a slowdown. It's kind of a good problem to have as we're funding growth here, and it's not a worry, in terms of what we think about every day. The cash would be not a worry in terms of our ability to deliver that. We've done historically. We'll do it in 2019, and there was good reason in 2018. The plan we always have is to increase turns. We usually plan at about a half a turn, but we always throttle it back. The trump card there is always on-time shipment, on-time delivery. When you've got sort of volatile order rates, particularly biasing upwards, we want to make sure we've got plenty of safety stock or increased compound sizes to be able to handle particularly hard-to-get components and parts.
We're just going to make sure that we're making hay while the sun is shining. Sue's point's exactly right, but we want to make sure to fulfill the growth and do it on time.
Right. Maybe even said another way, if the order book looks good as the year progresses, and you may have to build inventory again next year, and that's just a good problem to have.
Well, our growth rate's, the forecast's probably half of what it was last year. I think, to Sue's point, you're going to see working capital come down anyway there a little bit.
Right.
I think we comfortably get above 100% just based on that. It's a 12-round fight, so you need to think about how this is going to evolve over the year. If we've got a good outcome on some of the stuff that's out there, whether it's the debt ceiling negotiations or Brexit, or China-U.S. tariff discussions, if there's a blue sky scenario there, we're going to adjust as necessary to go fulfill that.
Yeah, no, that makes sense. Mike, just to follow on your comment earlier around talking about these large projects for several quarters, I recognize the lumpiness, but it'd be helpful if you can maybe talk about the pipeline, whether you see the pipeline as being pretty robust today or you are starting to see some of these projects come through and maybe a little bit less full than maybe what you saw over 12 months ago.
Yeah. Look, I think that these projects kind of go in sort of two to five at a time that are out there on the horizon. They take often two, three years to develop. Often put $10 or more million into the development of the project, you can imagine. As we get closer and closer toward thinking we've got something, we can certainly do that. This year we knew that we had one or two. Turned out to be the one really large one. There's a couple smaller, but in the magnitude of $50 million-$125 million that are out there.
Okay, great. Thanks, guys.
Thank you.
Your next question comes from the line of Andrew Kaplowitz with Citigroup. Your line is open.
Hey. Good morning, guys.
Hi, Andy.
Morning, Andy.
Mike, obviously there continues to be some concern that res HVAC for you will slow down at some point, given weak and new housing. We know you're projecting low double-digit growth for the resi market in 2019, based on replacement demand. Did your resi growth in Q4 match overall climate growth in the high single digits? Do you think 2019 could be another year of share gains for Ingersoll? Should we think Ingersoll grows more in line with the market in 2019?
You're talking about resi, Andy?
Yep.
Yeah. resi, really from 2013 to the present, I would say 18, for sure, consecutive quarters in a row, we've had share gain. We really changed the strategy in 2013, product distribution, the model, investments in digital. For 18 straight quarters without a hiccup, we've had share gain there. It was the same in the fourth quarter of this year. The markets there remain strong. You have to realize that 85% of what we do is going to be in the replacement market, not the new construction market. Think about the context of Ingersoll Rand. You think about residential HVAC as being less than 10% of our revenue. You can think about, obviously, you're talking about a really small number, 1%-2% being new construction. If that fell off even 20%, it would be a negligible dip for us.
We're really built toward the replacement market, I think that's going to continue to be strong.
Okay. Maybe, Mike, if I can ask you about the U.S. commercial HVAC market. Obviously, a lot of questions on the large projects, even ex that 13% organic bookings growth in the quarter was very strong. As you look into 2019, I think you mentioned in the prepared remarks that you have better visibility here than you've had. Some people still question how we're late cycle, if you look at the strength that you've seen, is it still broad based between institutional/applied markets and unitary markets? Is institutional going to lead the way in 2019? Does this backlog that you have really start taking you into 2020 at this point?
Well, a couple things, Andy. One is, certainly the applied business remains strong, I have to tell you, the strength of the unitary, commercial unitary market was really strong as well. This just gives us a general sense about the sort of underlying economic conditions in the U.S. are still pretty positive. It's got long legs to have had that kind of growth for this long, particularly the results we had in the fourth quarter in commercial unitary. The applied and institutional work continues to move along nicely. Education and healthcare, about 50% of that mix, we think that education continues to be strong. We think that the healthcare continues to be strong. No outliers there that we're seeing on that front. We think we've got a solid backlog built for 2019.
As I mentioned earlier on the question regarding the larger contract that we booked, Nigel asked, that thing's a four-year spend. I think this thing has got legs through 2019 for sure. Recognize too, Andy, for people that need, just to kind of keep it in context too, when you think about our commercial HVAC business, you got to think about 50% equipment, 50% service. You get to the equipment piece of this thing, it really breaks down pretty quickly between institutional and commercial. The large component of what we do there is still replacement buildings in the U.S. I think there's always an opportunity for us to have more energy efficient, more environmentally friendly ideas going into our customers. There's a demand creation opportunity here as well.
Appreciate it, Mike.
Thanks, Andy.
Your next question comes from the line of John Walsh with Credit Suisse. Your line is open.
Hi. Good morning.
Hi, John.
Maybe just to circle back to the margin bridge into 2019 for climate. Was just wondering if there's anything to call out in terms of mix. You obviously gave us the market growth rates for some of the sub-businesses, but is there anything Ingersoll specific there? Anything as it relates to the different growth rates between equipment and service as you think about the margin impact?
Nothing remarkable jumps out to me at all on the year. It's pretty straight stick. I think that we ought to be right in the ballpark there too, of 25% leverage. That'll continue to improve throughout the year. The mix, if anything, perhaps a little bit on the resi side or the TK side, because we continually expand more of the opening price point for the product line. With TK, there could be some mix with Europe being a little bit weaker and a bit more profitable than North America, a bit more maybe toward truck versus trailer in Europe. Little things on the edges, but I think it's a pretty straightforward year.
The visibility around the backlog for TK, particularly around North American trailer units and around auxiliary power units, is the most visibility we've ever had in that business. I think we feel that way about the backlog in HVAC entering the year as well too. Relatively straightforward planner, I think.
Got you. As we think about these restructuring benefits rolling through from the $94 million in 2018, you obviously call out the $0.25 and them having a four-year here payback. How should we think about what's actually carrying over from earlier actions into 2019, and then even starting to think about 2020, and what kind of tailwind some of these restructuring actions could have? Or is it going to be later than that?
John, the way I would think about it is the bigger pieces of the restructuring that we've been talking about in the footprint optimization arena between 2017, 2018, and what we're projecting into 2019 is sort of in the range of the five to seven factories and those less than five-year paybacks over time. You're going to continue to build. We started that process in 2017, and so you're going to build savings as you go through each of the years. There will be savings, obviously, in 2019, but there will be increasing savings in 2020, 2021 from these projects. Again, it is really about optimizing the footprint, building capacity and building a better Ingersoll Rand in the catching locations that's there, but it does provide a good return, and it does have a great payback.
I'd say, John, once we make these announcements into 2019, and as we think about extending the next round of long-term planning guidance that we do, this is something that'll factor into improved margins of cost, of course, lower fixed costs in the company going forward. I think we can probably help recast that sometime later in the year for all investors to understand the benefit of what's happened. We'll make a note to do that once we have announced our intentions.
I think, Mike, you made the point earlier in part of the discussions is that we're not looking at these opportunities as a way to get ahead of an economic environment. We're actually looking at these opportunities to actually operate really well, regardless of the economic environment. The fact that you can get a great return off of that in addition to making the company stronger is terrific.
Great. Appreciate it. Thank you.
Your next question comes from the line of Joshua Pokrzywinski with Morgan Stanley. Your line is open.
Hi, good morning, guys.
Josh Pok. Good morning.
Yeah, close enough, right? I mean, I'm used to it. Just on the industrial business, not that anyone should necessarily operate with a hard landing scenario, but thinking back to 2015 and 2016, I think some of the shorter cycle elements of that in tools and other industrial products caught you by surprise, and some of the decrementals there were a bit abrupt. How are you thinking about inventory levels, customer tone, and kind of distance from prior trough in the context of 2019? It seems like everything's fine, and I'm not being overly alarmist here, just trying to gauge what maybe the sensitivity looks like.
Well, first, back to John's question, when you think about sort of where all this restructuring spend has gone, the bulk of it to this point has gone into the industrial business, particularly into the compressor business. I think building a higher margin, more resilient business is certainly what they've been doing. The other piece of it is that service orders continue to outpace equipment growth, certainly again in Q4 too, and that is both service penetration and its sheer wallet strategies for our CTS business. We believe that from what we're seeing here, there is certainly a balanced view toward what could happen. Clearly, if there is some certainty around China-U.S. tariffs, we think certainty, no matter what the outcome of that could be, is probably going to unlock a little bit of growth there.
I think it's a balanced view at this point in time, but I think we've planned for a lower fixed cost base through restructuring through higher service mix. That business has been prolific around investing back into the business. I want to say it was a full 50 basis points going back into industrial, and I think that that is always a sign of healthy business investing. In a downturn, you can take share, and we want to make sure that happens, and we're taking share in a downturn, too.
Got it. That's helpful. Just thinking about some of these larger projects in Climate, I would imagine as the cycle wears on, you see more and more large projects show up. How should we think about that in terms of operating leverage when those ship? I would imagine some of that, especially in performance contracting, is some pass-through revenue, not just all your equipment. Is there a margin hit that comes in with that or a lower incremental, or does it kind of feel like normal equipment?
Yeah, it can be, Josh. Not particularly in this case. I don't think this one's going to be something that spikes out materially anything with leverage or incrementals. The margins on those projects are not bad, as we've talked in the past. You've got to look at the contribution margin to the entire business. Usually, those projects have everything from an SG&A perspective loaded into the contract as well. There's very little between contribution margin and operating income there left to look at. I feel positive on that. Again, they're hard to forecast. We don't put them into base plans. When we think we've got something that's got a high probability of closing, we might start to talk about it. Certainly, when they're the magnitude of what we've booked, we'll have to spike those out so we get everything straight from a comp perspective.
I hope that answers your question.
Sure does. Thanks, Mike.
Your next question comes from the line of Andrew Obin with Bank of America Merrill Lynch. Your line is open.
Yeah, good morning. Can you guys hear me?
Good morning. How are you?
Hey, I'm good. Just a question. A lot of questions have been answered. Thanks for including me. Just can you give us visibility on the institutional side? I know you guys look at state and local funding and bond issuance. How much visibility do you have for funding on the institutional side in HVAC in North America because it is a key market for you guys?
There's a lot of metrics to look at there, Andrew. Certainly, you all can look at ABI, GDP growth, non-resi fixed construction. All those look good. We've got the benefit of looking at-
I was more interested. Yeah, you guys track bond issuance and sort of longer-term metrics from local government and state government, though those tend to be useful. Sorry.
We do as well, you guys certainly can look at that. The most important thing we can track, though, is we put a lot of investment into the systems we use on the front end of the commercial process. The ability for us to understand pipelines better really support strong institutional growth going forward. I could just tell you the number of and size of projects from the institutional perspective are very healthy. This goes back to the question around 2019 and climate, what confidence do you have? Or maybe even to the larger Ingersoll Rand question, what kind of confidence do you have in the guidance that you've put out? I've got a high degree of confidence in what we've put out today on all of that.
I would say at the heart of that is because I feel very strongly about what's happening globally around HVAC compliance and certainly greenhouse gas emission visibility around institutional growth in North America and around the visibility we have into the TK business. Those are all very strong indicators that I look back over 10 years of doing this, I probably haven't had at least the visibility I've got now into the backlog.
That's a great answer. Thank you. Just to follow up on the industrial compressors, how much of a headwind is automotive for you? If it is a headwind, which industries are offsetting this in North America? The orders are quite good as well. Thank you.
Yeah, sure. Andrew, when you go back and you look at some of the pie charts that the business produces when we do Investor Day, it shows the end markets that we serve, you run out of colors and slivers on the pie chart. Automotive's a piece, but it's probably not more than 2% or 3% of what we do. Electronics is a piece. It's not 2% or 3% of what we do, pharma and food and beverage, so on and so forth. Automotive, per se, is not critical, but it is indicative of a broader slowdown at times. It's indicative of other spending in the economy. We watch automotive, when we see automotive slow down, it can be a leading indicator for us, for sure.
What's strong in North America? Are there any end markets that stand out as strong to you guys on the industrial side?
Industrial markets that remain strong would be food and beverage, pharma. Anything oil-free would certainly be strong for us. Some of the weak to moderate markets are still going to be larger compressors where customers might be waiting on capacity to understand what's happening with trade.
I will now turn the conference back over to Zac Nagle for closing comments.
Excuse me. I'd like to thank everyone for joining today's call. As always, Sue and I will be available over the coming days and weeks to take any questions that you may have. Certainly reach out to us if you'd like to chat. We look forward to seeing you all at the upcoming conferences in February, and we'll be on the road in March as well. Thank you.
This concludes today's conference call. You may now disconnect.