PX – Still Our Best Idea for 2018

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SEE LAST PAGE OF THIS REPORT Graham Copley

FOR IMPORTANT DISCLOSURES 203.901.1629

gcopley@ssrllc.com

July 8th 2018

PX – Still Our Best Idea for 2018

  • Praxair has been out top stock pick for some time and our conviction level today is higher than it was when we first produced a pro-forma earning model for the combination with Linde a year ago.
    • We see the likelihood of the deal being approved increasing with the agreement to sell a large part of Praxair’s European business to Nippon Sanso.
    • The price paid for the assets is a higher multiple of sales than we had modeled and consequently our share buyback assumptions were likely too low
    • The underlying business is better today than we expected it to be a year ago.
      • This fully justifies PX’s share price today – suggesting that the stock price is currently not pricing in any positive impact of the merger
      • It also gives us a higher earnings base for 2018 as a starting point
  • Our earnings bridge to 2022 is summarized in Exhibit 1 and it generates a higher 2022 EPS than we had forecast previously – in this case greater than $17 per share. The growth is driven by the following:
    • Synergies – assumptions that we have not changed since the initial model
    • Incremental revenue growth – in 2021 and 2022 because of larger and more profitable capital deployment from 2019 – assumptions unchanged
    • A significant share buyback (20% of outstanding shares from 2019 through 2022) – this has increased because of the higher asset sales price (even if this means a higher tax bill).
  • EBITDA based valuation analysis and forecasts can justify a share price in excess of $400 by 2022, but our earnings analysis and a more conservative multiple gets us comfortable with $370 – 125% upside over the next 4 years.

Exhibit 1.

Source: Capital IQ and SSR Analysis

Details

We have been big fans of the PX/Linde deal since the announcement of the deal and its structure a little over a year ago. During the rumor phase we were concerned that PX’s motivation was a stagnating business environment and stalled growth in part because of a stalled capital base. At the end of 2016, PX was coming off two years of zero “normal earnings” growth because of limited opportunities to deploy capital – Exhibit 2. It became worse in that capital dipped again before recovering from 2017 – Exhibit 3.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

At the time the merger was announced we produced an earnings model that assumed a large buyback of stock and some impressive income growth driven by synergies and opportunities to capture a larger share of the industry growth – we first published an earnings model in August of last year and at the time projected a 2022 EPS between $15 and $16 per share and a PX based target price of $300 per share by that time.

As is shown in Exhibit 1, we have revised those numbers upwards, and as summarized in the Exhibit 4 we expect impressive EPS growth for the combined company and 2022 earnings closer to $17.50 per share. So, what has changed?

  • We expected asset sales at 3x sales and the European deal announced this week is at more than 4x sales – accordingly we have increased our divestiture revenue – at the same time increasing the gain on sale – the higher bar in the chart below
    • This leads to a higher share buyback – 20% of the outstanding base through 2022 – even with higher assumed stock prices – Exhibit 5.
  • Industry fundamentals have improved and PX has seen much better results – partly shown in the chart above, but more prominently reflected in Exhibit 6 – which looks at return on capital.
  • We have not changed our synergy assumptions or our assumptions on capex

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Current valuation for PX gives zero credit for the deal and the earnings growth opportunities. The stock looks expensive on a “normal” basis (absent any deal credits) – Exhibit 7 – but the “skepticism index” for PX is essentially zero (Exhibit 8) – because the slight overvaluation is in line with the over-earning as shown in the return on capital chart above.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

So, according to our valuation methodology, which as a reminder has been a rock-solid foundation for more than 25 years covering the Chemical sector, PX’s share price is only showing credit for current improving industry and company fundamentals (and returns) and is showing ZERO credit for the deal. If the deal does not go through, there may be some sentiment driven downside but today there is no fundamental reason for it.

If we haircut our estimates for the deal synergies and share buyback opportunities and assume that forward pro-forma “normal earnings” are $10 per share – as opposed to the $12.50 we expect in 2020 – our current valuation model generates a target price of $212 per share. If we use the $17.50 2022 estimate the model shows $370 per share – 125% upside over 4-5 years.

With the announcement of the European asset sale this week – we see a deal with significant potential upside now more likely to close, and better underlying business at PX justifying current valuation; and limiting downside if the deal does not close.

Note: our model is a simple combination of the two companies and will likely be wrong in two ways once the deal is done:

  1. As with DWDP, it is likely that there will be a purchase of one company by the other – Linde buying Praxair. This will create a significant level of goodwill and other intangibles on the merged company’s books – as it has with DWDP.
    1. EPS numbers will likely be lower than we are estimating because D&A will be higher – we cannot quantify by how much and see no point in making an estimate.
  2. The flip side of this is higher free cash flow (less tax) and this could mean a higher buyback or increased capital spending – more likely a higher buyback

We have included a chart of EBITDA per share to remove the unknown D&A issue – Exhibit 9. We would expect the combined company to have around $30 of debt per share in 2022. Currently PX has an enterprise value that is around 14x EBITDA. If we applied the same multiple in 2022 we generate a per share equity value of more than $400.

Exhibit 9

Source: Capital IQ and SSR Analysis

©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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