Praxair – An Unusual GARPY Opportunity

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Graham Copley / Nick Lipinski

203.901.1629 / 203.989.0412

gcopley@/nlipinski@ssrllc.com

November 24th, 2014

Praxair – An Unusual GARPY Opportunity

  • Praxair is cheap. It is extremely unusual to see PX trade at its current level of discount to its own history, Air Products, the Chemical Sector and the Industrials and Materials sector. In recent research we have suggested that maybe there are too many choices in the Chemical space today and PX is being left behind – presenting an opportunity.
  • Praxair’s capital discipline has set it apart in the past and there are no indications that the company has altered its approach in any way – maintaining high hurdle rates for projects and returning cash to shareholders when there are not enough good opportunities.
  • Industrial Production is weak outside the US and has been a specific problem for PX in Brazil, Mexico (in the energy space), Europe and China. Facilities are underutilized and while this hurts earnings in the near-term, it provides very strong operating leverage for the future.
  • Recent management meetings suggest that significant capital spending may be limited to the US and India for the near-term. The company continues to chase bolt on acquisitions but these tend to be in the packaged gas space and are small.
  • Pricing remains robust and rhetoric from both APD and Linde suggest that they are both trying to emulate PX’s model and this may help pricing going forward. More disciplined capital allocation may allow PX to make higher returns in competitive bidding situations and see real value from its lower construction and operating costs.
  • PX is earning roughly $1.00 per share below its “normal” level in our view and is some 25% below its “normal” value in our model. It is not clear that there is a short term catalyst to cause a quick correction, but this is a steady growth story without a “growth for growth’s sake” attitude and a history of raising dividends and returning spare cash to shareholders.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

Praxair has generated significant value for shareholders over the last 15 years and in our recent piece on capital allocation we highlighted PX as one of the few chemical companies with a fairly consistent track record (Exhibit 2). PX has been the safe buy and hold option in the space and many major shareholders have held the stock for a very long time for its predictability of earnings and the steadily increasing dividend.

However, despite the high “share appreciation” bar in 2013, PX has underperformed the market and the sector for the better part of 2 years. Growth has slowed and earnings have missed expectations, both on the sell side and on the company side – unusual for a company that has been the poster child of conservative guidance.

So what is going on? Has something fundamentally changed in the industrial gases business or PX and is there a reason to think differently about the stock?

Exhibit 2

Source: Capital IQ, SSR Analysis

We had the opportunity to visit clients with PX management (CFO) last week and as we reflect back on the meetings that attended, the focus of the questions and discussions fell in a couple of buckets:

  • As suggested above: Is anything broken?
  • Has anything changed in terms of capital deployment discipline?

On the broken question – PX has disappointed on growth over the last couple of years and is signaling lower capex going forward.  There is some concern that the business model we all know and love may have changed, however:

  1. Growth is low because IP is low and IP is the primary driver of industrial gas demand. Incremental manufacturing demand drives the merchant (liquid) and packaged gas sales that allow industrial gas companies to achieve higher operating rates and higher margin on facilities which are for the most part base-loaded with one or two anchor “take or pay” contracts.
    1. Q3 was particularly impacted by very low IP in Brazil (post the World Cup) and energy cost reductions from Pemex, leading to lower activity – both of these likely continuing through Q4
    2. Slower growth in China has exposed the overcapacity in the merchant market leading to weak pricing – PX’s No. 5 position in the country is likely a relative benefit today. PX is cutting costs in Asia/China by shrinking management layers.
  2. If all these issues get corrected, growth would be better but not back to historic highs because the overall level of activity has fallen – hence the more limited capital investments
    1. Strong and likely increasing backlog in the US (petchem related) and in India – but not much expected elsewhere.
    2. Opportunities in energy with “dry frac” but this is increasing use of Nitrogen/CO2 and could be a steady gain rather than a step change.
    3. Happy with Russia – some delays in conmstruction but returns look good.
  3. PX is still getting growth from acquisitions, but these are small and not game changers, and from pricing, which continues to show steady overall improvements
    1. PX is encouraged by public comments from APD and Linde on pricing and capital discipline but has not seen evidence in the market yet.

Our view is that PX has lots of underutilized capacity as a result of the slower growth and this explains part of the departure from return on capital trend in Exhibit 3.  Some of the decline is the goodwill impact of the NuCO2 acquisition, but we would expect the company to get back to at least the trend with some better economic growth.  Consequently we have PX “normal” earnings about $1.00 per share higher than current.

Exhibit 3

Source: Capital IQ, SSR Analysis

On the capital discipline question, nothing has changed. Hurdle rates have not come down, despite the low cost of debt and almost free CP for PX.  The company is taking on projects where the economics work and handing cash back to shareholders in the form of buy-back when they do not have enough good project opportunities.

  1. The backlog has some upside if some of the US petchem bids come through but ethylene plants do not use much industrial gas and it is the second round of investments that need to be inked in before PX has firm commitments – products like ethylene oxide, propylene oxide and ammonia. These could be chunky.

Overall, this remains a good story and it is on our chemical focus list because of this and because of its unusual relative discount. As we discussed in our recent Chemicals Monthly , investors are spoilt for choice in the chemical space today with the ethylene story, the activist story and the number of deals – PX has, in our view underperformed partly because there is not much of a current story.

Our “normal” value for PX is around $165-170 per share, but it is unclear if there is a catalyst that will close the gap quickly. PX is unusually cheap relative to its own history, relative to its most obvious peer, APD, relative to the chemical industry and relative to the industrials space.

Growth

Praxair’s growth has slowed from the high levels of the 2005 – 2009 period, but is close to historic average and trend since 2000. While the sales “trend” in Exhibit 4 shows a very slight negative slope, the EPS “trend” shows a slight positive slope, despite the recent weaker numbers. The company continues to leverage incremental sales into higher incremental EPS.

Exhibit 4

Source: SSR Analysis, Capital IQ

But PX is not unusual in the US and the revenue charts are similar for all of the players – Exhibit 5. PX has fairly consistently outperformed Air Products, with some of the pattern difference explained by September year-end for APD and March year end for ARG. Much of the ARG growth has been acquisition driven, though both APD and PX have had acquisition help. Note that we are only looking at gases for APD so the chart is not influenced by the chemical divestments.

Exhibit 5

Source: Capital IQ, SSR Analysis

For all of these companies there is a very strong revenue correlation with Industrial Production, and the low numbers of the last few years explain the slower organic growth. ARG benefits from being exclusively focused in North America where the economy is stronger. PX also has very good North American exposure, but has been hurt in 2H 2014 by a market slowdown in E&P activity by Pemex, which has hurt sales in Mexico, where margins are very high.
Capital Discipline remains high

In our view, the primary reason why Praxair has grown so well over the last 15 years, and until recently eclipsed ADP, is because of its capital discipline. Capital expenditures have risen – as shown in Exhibit 6 – but have declined as a proportion of revenues in 2013 and 2014, as good investment opportunities have become more limited.

Unlike other companies, PX has maintained its hurdle rates, while others appear to have compromised as the cost of debt has fallen. PX has maintained a healthy level of capital spending without compromising hurdle rates because it has also focused on cost and productivity gains on a continual basis. Praxair has spent a higher proportion of revenue than APD – Exhibit 7, both because it has higher margins and therefore higher levels of free cash flow, and because it has been able to find ways to spend capital efficiently – the company claims that in 50% of its new capital decisions, it is either the only bidder or only has one competitor.

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

Growth from acquisitions can come at a return on capital cost. The NuCO2 acquisition brought with it almost $700m of goodwill and this has been part of the reason why the company is off its otherwise very impressive return on capital trend – discussed later. Acquisitions are expected to continue, but going forward they are likely to be small packaged gas opportunities in the US, which will not move the needle on an individual basis. We expect some asset swap opportunities to arise as APD looks to improve its portfolio, but PX will likely only be successful in locations where it is the obvious winner. PX’s acquisition spending is summarized in Exhibit 8.

Exhibit 8

Source: Capital IQ, SSR Analysis

The larger opportunity here remains achieving higher returns on existing assets as economies improve and while we expect the company to continue to chase appropriate capital spending opportunities we do not expect any compromises on discipline and expect increased buy-backs to balance lower capital spending opportunities as we have seen consistently in the past.

Valuation

Praxair is very attractively valued, which is a very rare occurrence, and it has not been this far below normal value in the last 10 years – Exhibit 9. Despite this discount, the stock screens unattractively on our skepticism screen, suggesting that returns on capital need to rise to justify even the current price – Exhibit 10. The reason for this disconnect is that returns on capital today are more significantly below trend than valuation is below trend – Exhibit 11. Part of the reason for this is the added goodwill with NuCO2, which there nothing PX can do about, and the rest is the capital bubble from 2011 to early 2013, much of which is yet to start-up and generate returns, as well as the general level of underutilized capacity.

While returns are lower, leverage to a recovery and to the startup of capital projects nearing completion is very high.

Exhibit 9


Source: Capital IQ, SSR Analysis

Exhibit 10


Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

But PX is not just cheap relative to its own history – it is cheap relative to APD ( something we have written about previously ) – Exhibits 12 and 13; it is cheap relative to the chemical sector – Exhibit 14 (the recent correction is the selloff of the commodity sub-sector), and it is cheap relative to the entire Industrials and Materials sector – Exhibit 15

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: SSR Analysis, Capital IQ

Exhibit 14

Source: Capital IQ, SSR Analysis

Exhibit 15

Source: Capital IQ, SSR Analysis

©2014, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. 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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