Air Products and Praxair – A Tale of Two Strategies

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

April 25th, 2014

Air Products and Praxair – A Tale of Two Strategies

  • We continue to believe that PX will outperform APD for the balance of 2014 on both a business and stock basis. We expect that PX will outperform APD on the earnings front all year with relative positive revisions/surprises – most likely manifesting as negatives from APD.
  • Short-term, the trends in APDs gases business are not good, with operating margins falling steeply over the last two quarters. PX saw a fall in Q1 2014, but this was in part due to the near term dilution of the NuCo2 business and not operational – we expect PX to show improving trends in margins and return on capital in the second half of calendar 2014, we do not expect the same for APD.
  • PX is at a valuation low relative to APD and we would not be surprised to see relative valuation to swing back towards PX quite significantly over the balance of the year.
  • The upside risk in APD would be from a positive surprise on the CEO announcement. We are of the view that even the ideal CEO candidate cannot change the trajectory at APD quickly and will only have some near-term cosmetic moves to make. The bigger issues around cost and construction/operational competitiveness will take a long time to correct, and in the meantime we may see further margin/return on capital dilution as new capital projects come on line.
  • The downside risk at PX is Latin America, where the exchange rate is a problem and where both the world cup and Brazilian elections could result in demand slowdowns this year. Russia is also a risk, but it is a small exposure.
  • If PX were to reverse the relative value move of the last 15 months, as shown in Exhibit 1, the relative upside for PX/downside for APD would be 42%.

Exhibit 1

Source: Capital IQ, SSR Analysis

Valuation spread based on difference between PX and APD discount from normal value

Overview

The conventional view is to compare PX and APD closely because they are essentially in the same business, but the companies have embarked on different strategies as they operate in the same business areas, and in our view this is driving quite distinct performances. PX has focused on costs control and efficiency and spends as much time and rigor looking at small dollar capital decisions as it does large dollar decisions. Air Products has spent less time addressing capital and operating costs, in our view, and is more comfortable making larger capital decisions than smaller ones.

One consequence of these divergent strategies, again in our view, is that Praxair’s risk has become more and more diverse and dispersed, whereas Air Products runs the risk that its business risk becomes more focused and less dispersed. Investors pay up for this industry for two reasons – the growth (i.e. the ability to redeploy cash at a higher return than can be generated by returning it to the shareholder), and the relative consistency of earnings.

In a period of strong synchronous global economic growth – such as the period from 2002 to 2007, all of the industrial gas companies were able to deploy cash, plus incremental borrowing, on projects that were for the most part returning well above the cost of capital. As the economy has slowed not only has it taken longer for capital spent in the 2006/2009 period to generate positive returns, but it has also been harder to find investment opportunities with the returns that were possible prior to 2007 – fewer opportunities results in greater competition for those that exist.

Volatility comes from a number of sources:

  • Macro moves in economic and manufacturing growth.
  • Overspending versus a disappointing macro environment – tends to lower return on capital while demand catches up – this has been the case over the last couple of years for both PX and APD – the opposite also applies, though is more muted as operating rates can only rise to a limit and there is no material spot market to allow prices to react steeply to shortages, given that shortages tend to be very local in nature.
  • Greater dependency on larger projects in more concentrated geographies – this tends to increase both customer and specific economic risk. We would argue that APD’s strategy of the last 4-5 years has resulted in more focused risk and will likely lead to greater volatility.

If companies deploy capital at declining rates of return, earnings growth will slow. If volatility increases, investors will pay less for those earnings. We believe that APD has both of these risks in front of it in absolute terms and relative to PX. Consequently we would expect earnings revisions/performance to improve at PX relative to APD.

We would expect the line in Exhibit 1 to turn sharply positive and retrace back to where it was at the beginning of 2013 – the relative upside in PX versus APD is around 42%.

Air Products Gases – Overspending In the Wrong Places?

The last four years of gases data certainly raise some question for Air Products – Exhibit 2 – the operating margin line has the wrong slope and the slope is accelerating. As the same time revenues are fairly static despite significant capital spending across the entire period – APD has made a number of divestments – but they have been more in the Chemical business in recent years and so consequently, with the exception of homecare, have not materially impacted gases revenues. By contrast, PX has an upward slope to its operating margin trend and sales are growing – Exhibit 3. These companies are generally faced with a similar set of investment opportunities, but clearly one strategy is working better than the other. Capital spending for the last 8 years is summarized in Exhibit 4, and while spending levels are different because of the relative sizes of the companies they follow a similar pattern.

Exhibit 2

Source: Company Filings

Exhibit 3

Source: Company Filings

Exhibit 4

Source: Capital IQ, SSR Analysis

Praxair has a much higher operating margin than APD but this has not always been the case – Exhibit 5. There was a point at which PX moved consistently above APD and the gap continues to widen. This has been driven by the different investment strategies at each firm and the more granular approach towards plant loading and regional density at Praxair has clearly been more effective so far.

Exhibit 5

Source: Capital IQ, SSR Analysis

In the title of this section we suggest that APD’s problem is spending too much in the wrong places relative to PX but we should be clear that we do not have enough data from either company to prove that this is the only reason for the performance divergence. It would be the most logical reason, but given the nature of the business there is no doubt that there probably exist APD projects that have performance in the upper quartile of the combined companies and PX projects that are in the lower quartile.

Absent A Change in Strategy we expect more of the same – Even a near-term change in approach at APD will NOT have an immediate impact.

All things being equal, we would expect the negative margin trend at APD to continue through the balance of this year and we would expect the trend at PX to reverse by mid-year and start improving. This will result in a greater divergence of earnings and probably revisions/surprises.

APD needs a strategy refresh – this is clearly the point that Pershing Square is making and the results in the gases business would be supportive of that view. However, the capital decisions of 2012, 2013 and 1H 2014 cannot be reversed and need to play out, in our view resulting in more disappointing results at APD before a turn – regardless of who is at the helm.

Near-term a new CEO has few degrees of freedom to make an impact:

  • Cutting back capex would send a good signal perhaps but would not materially impact near-term results
  • Asset swaps in regions where APD does not have critical mass or adequate density could have a more short term impact, but APD would need someone to trade with.
  • Selling the Chemicals business would not work in our view because it has a higher multiple in APD’s portfolio than it would outside. A sale would be dilutive and would get rid of the one business in the portfolio moving in the right direction – see comments later in the CEO section

In our view, with the best strategic plan in the world, APD would likely take two years to be in a position where it could start reversing the trend in margins and returns on capital. During that time we could see some negative news flow as businesses and people are repositioned.

The Risk – A Truly Inspired CEO Hire

This is a headline risk only in our view – but a risk all the same. APD needs a good operator and someone willing to make some hard decisions. As we have written in prior research the company has lots of things to focus on and most of the fixes will take some planning and then some time to implement.

On the conference call the suggestion was made that a new CEO would be announced by the end of June – the outer limit of the time frame originally suggested. While we have no indication of where the search may be leading, and understand that the committee is looking for an outsider, we do think the numbers suggest there is an internal candidate who should get some consideration.

While the gases business at APD has been disappointing, the chemicals/electronics business has been doing very well – Exhibit 6. Despite not much movement in revenues, the business has seen significant improvements in margins and profitability since late in 2012, suggesting a strong focus on costs, operations and business mix. We believe that this sort of progress could be made in the gases business (particularly in the US) with the right focus, and while it would only be part of the long-term broader strategic reshape the company needs, it could certainly help near-term. Coincidentally or not, this improvement in the electronics and materials business has come with Guillermo Novo at the helm. Mr. Novo joined from Dow (and previously Rohm and Haas) in the middle of 2012. While five quarters do not make much of a trend, it is the best looking trend at APD at this time.

Exhibit 6

Source: Company Filings

©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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