Air Products – The Investment Controversy

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SEE LAST PAGE OF THIS REPORT Graham Copley

FOR IMPORTANT DISCLOSURES 203.901.1629

gcopley@ssrllc.com

August 21rd 2018

Air Products – The Investment Controversy

  • Air Products is not an expensive stock, and using our Skepticism methodology in fact looks quite cheap – so why are we negative on the story? Two reasons:
    • Our valuation work is empirically based on a very long history for industrial gases and for APD specifically – today, APD is perusing investments that will change the shape of the company from the base against which all the historical context is driven.
    • APD has begun to see a decline in returns on capital and recent investment announcements suggest that the trend will continue. The opportunity suggested in the skepticism work may go away due to returns on capital falling rather than the stock price rising.
  • The shape of APD is changing as more and more capital is directed to large projects and gasification. Back in 2012 the company began directing capital the same way: returns on capital fell and the stock was punished for it.
    • We buy the argument that financial controls may be better today than they were in 2011 and 2012 and that the projects possibly carry less risk – but they are still outside the US and they are moving further downstream, while consuming more capital.
    • What is considered traditional industrial gas business is shrinking at ADP – the correlation with PX, that lasted for 15 years, has completely broken down with APD valuation more volatile although the stocks are still similarly valued.
  • The sell side almost unanimously loves APD – the last time this was the case, it was a very clear sell signal for the stock.
    • Although the stock has underperformed for the last 2 years, there is still downside as this new business model evolves and the multiple comes under further pressure.
    • We have a strong preference for PX but note that while the stock is not expensive, there would be sentiment driven downside if the deal with Linde falls through.

Exhibit 1.

Source: Capital IQ and SSR Analysis

Details

We have written extensively about APD in several of our weekly emails over the last few months. The stock presents, in our view, a unique set of investment controversies today driven by the following:

  • First, a widely loved CEO who has done a very good job of taking a sleepy underperforming company in a very good business and injecting some life. Cost have been reduced, business management has become more focused and the stock has done very well.
    • Somewhat uniquely, for this broad industry group, the CEO was given the benefit of the doubt on arrival by investors and the outperformance in the stock came on the change in leadership – well ahead of the delivery. APD has underperformed the market significantly since June of 2016.
  • Despite new and redirected leadership, APD still remains largely uncompetitive in the traditional air-separation segment of the industrial gas business from the perspective of bidding, design and construction of facilities. At the same time its geographic footprint in this segment seldom creates an opportunity where APD is the investor of choice for new traditional facilities.
    • This is further hindered by an overall need for new (traditional market) investment that is well below the free cash generation of the major players. Some are buying back stock – all are looking at acquisitions.
  • Rather than buy back stock APD has elected to deploy all of its capital (including incremental borrowing) in fixed assets and has chosen to do so by straying from the traditional industrial gas playing field and is making an outsized bet on gasification – mostly for syngas manufacture, but in the case of the recently announced Jazan (Saudi Arabia) deal is moving downstream to power generation.
    • The company has increased its dividend at an above market rate for the last 4 years.
  • All of the large investments APD is making (so far); 2 in China and the one in Saudi Arabia are expected to generate returns that are in excess of the companies cost of capital. But..
    • They are likely dilutive to overall return on capital – especially the most recent China announcement.
    • They carry both currency and political risk – however “ironclad” any “take or pay” contracts might appear
    • They are very chunky blocks of capital – levering APD towards large facilities that will likely take occasional shutdown and create greater earnings volatility for the company.
    • While this is a new management team, APD has a very poor history when straying outside its core business and it was interesting to note how insistent the company was on the Jazan call that no new technology was being used at the venture.

APD is taking the gasification business very seriously and recently acquired Shell’s coal gasification technology, which should adapt easily to the high sulfur resid/fuel oil project in Saudi Arabia and is core to the ventures in China. This could turn into a very large business for APD, especially if other refineries look to resolve the impending high sulfur fuel oil limits by choosing the gasification option.

These are not small projects and with APD already committed to having around 20% of its capital base in this business by 2020, it is not much of a stretch to see this move closer to 50% by 2025 as traditional industrial gas units become fully depreciated.

So, the question we keep asking, is what do you pay for a company with a declining trend to its return on capital and the expectation that the decline will continue, as well as a shift in business mix away from the traditional industrial gas model and towards something that looks more like a utility (large facilities – each accounting for a meaningful share of earnings and consequently risk).

The stock is not expensive – Exhibit 2 – and even less so when you look at return on capital relative to trend, Exhibit 1 and how that drives our skepticism index – Exhibit 3. However, a high skepticism index can be corrected in two ways – either the stock rises or the returns fall. We already have falling returns at APD (Exhibit 1) and with the jump in capital expected in 2019 from the Jazan project as well as the latest China venture – illustrated in Exhibit 4, we expect returns to keep falling. The new China project will return less than 7% if you assume no interest value on the capital – less than 10% if you use an implied 3% alternative value for the cash.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

APD is off its relative multiple highs and has conceded the top spot back to PX in recent months – Exhibit 5 – but both stocks have high relative multiples versus the broader chemical space. This is widely credited to what are supposed to be more predictable and less volatile business models; but interestingly one standard deviation of movement in stock value for APD is very similar to the same measure for DOW over the very long-term. For PX the volatility is higher than both APD and DOW, but we have a shorter timeline for PX which may impact the results. Earnings volatility for the gas companies is much lower than for the broader industries even if the stock volatility is the same.

Exhibit 5

Source: Capital IQ and SSR Analysis

Our valuation concern for APD has been proven correct since the middle of 2016 as the relative multiple has come down from its peak, but the lows of 2011 and 2012 were a consequence of very similar capital allocation decisions that are being made today. They were being made by a management team that does not enjoy the same level of investor and sell-side support that APD has today – Exhibit 6 – which shows a clear “sell” signal based on our work on recommendations and was clearly a sell signal in 2011/12.

Exhibit 6

Source: Capital IQ and SSR Analysis

However, Exhibit 5 would not suggest much further downside – perhaps a couple of relative multiple points to get back to early 2013 lows. But that assumes that the APD we are using as an historical proxy is appropriate. What if half the company begins to look like a utility – lower return – “guaranteed margin” based payments – operational risk and county and currency risk. Excluding NextEra, the 9 largest utilities in the world have an average forward P/E of around 16x versus APD at 20x.

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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