Strong Manufacturing – Buy Industrial Gases

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Industrial Gases generally and Praxair specifically are being left behind by the manufacturing related rally that has boosted values for many industrial and material names over the last two years.  Arguably, both Praxair and Airgas, through their extensive US packaged gas and merchant gas businesses should see more leverage to better US industrial production and manufacturing, than many other sectors and companies.  This logic applies also to Air Products, but to a lesser degree given its lack of packaged gas in the US.

Both this year and last year we have been disappointed with results from all three companies given the improved economy in the US, but the operating leverage is real – particularly for PX and ARG – given underutilized assets in the US and very high potential incremental margins.  Praxair’s return on capital is expected to return to its long-term trend assuming estimates are appropriate for the next 12 months (PX estimates are historically conservative) – see chart – but the opportunity is to return to the more recent trend – post the reshaping of the company in the early part of the last decade.  There is enough leverage in the US focused business to achieve this as demand improves.

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Despite the improving trend in the chart above and even assuming the lower “normal return on capital” trend, PX is out of favor, with attention focused on APD and the new management.  As we have written in prior research PX is very cheap versus APD (second chart) – despite having the greater US manufacturing leverage.

In our view the opportunity today is in PX. ARG offers a more focused US exposure without the risks of Asia, Europe and Latin America, but does not have the valuation discount.

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