Praxair – Compensating For Lack Of Growth!

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 2nd, 2016

Praxair – Compensating For Lack Of Growth!

  • Praxair’s re-engagement with Linde is a clear indication that management believes that this deal, however complex it might be to construct, offers the best longer-term opportunity for the company to create shareholder value. But we would not buy the stock today!
    • It is an admission that the slower growth and more limited capital investment opportunities of the last three years are here to stay – the organic go-it-alone strategy will likely not work.
    • Consequently, faced with the options of either going “off-piste” for growth or trying to make something happen with Linde, Linde is the first choice.
  • We should not underestimate the senior management compensation driver behind this move also, as PX’s compensation plan is very geared to shareholder returns (which is good) and without growth the company risks further relative multiple erosion.
    • As long as required divestments are not too extreme, a merger with Linde gives the combined company some revenue growth opportunities but much more synergy and cost related growth drivers to earnings.
    • We would also not be surprised if the deal triggered a “Change of Control” at PX – a further possible motivation for PX to want this deal to work, but important as it should make PX management less concerned about control and more focused on creating value.
  • Our valuation and margin analysis suggests that there is a lot that a PX style of management could do to improve the returns at the Linde business – Exhibit 1.
    • We think that PX would want to sell Linde Engineering as we suggested in earlier research.
  • Should this deal work, the clear loser in our view is Air Products, given that both PX and Air Liquide will have acquisition driven growth stories and APD would become a very clear No 3, even if the company could pick up some assets stranded by the PX/Linde deal.
  • We would own Linde and Air Liquide today – PX could be a great longer-term story, but depending on the deal structure could see downside first, given very high current multiples.
    • APD either steps up to compete for Linde or gets relegated to a small 3rd player – either way we see risk to the share price.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

Praxair is again engaged in discussions with Linde about a possible merger of equals. Notwithstanding all of the issues around deal structure, whether or not the regulators will let it happen, how the merged company will be managed, etc., it is perhaps important to talk first about motive.

The consensus (industry expert – as opposed to sell side) view is that this deal will not pass muster with the regulators, or if it does, it will only do so with such a significant level of required divestments that it may not make any sense at that point. There are only four major players in the business, every significant deal done since 2000 has required divestments of some sort, and regulators prevented the acquisition of BOC by Air Products in 2000. So why even try?

The golden age of the Industrial Gas industry came during a period in which both returns on capital and the capital base itself was growing. Today we have a much slower growing global industrial world – resulting in fewer opportunities to deploy capital and greater competition to create growth, limiting pricing and damaging returns on a slower growing capital base. In our model, Praxair’s normalized earnings growth has come to a grinding halt – Exhibit 2!

Exhibit 2

Source: Capital IQ, SSR Analysis

Praxair is not uniquely positioned here:

  • Air Products has also seen its normalized earnings stagnate as the opportunity to deploy capital profitably has declined. Part of the problem the company faced prior to the change of management focus was a determination to keep deploying capital even as the marginal returns fell.
    • It is unclear to us what APD does next, given the recent cost cutting and divestments as the company now runs the risk of falling into a Praxair-like growth stagnation.
  • Air Liquide has made its growth bet with the acquisition of Airgas, driven in part by a desire to increase its US footprint, but also by the opportunity to invest new capital behind Airgas.
    • Air Liquide’s opportunities in the US will come at the expense of those currently supplying Airgas – such as PX and APD – and, while they may not be dramatic and will likely only be in select locations, will cut into incremental margins for both.
    • We believe that the Air Liquide story may be the best within the Industrial Gas space today – supported by very attractive valuation and reasonable yield – see Exhibit 1.

Growth – or lack of it – is driving the strategy at Praxair, and it seems that management believes that the potential costs of getting this deal done – if possible at all – are worth the efforts given the alternatives. Praxair has a very shareholder friendly and aligned management compensation structure and as shareholders have seen little growth over the last couple of years, Praxair’s senior management has also seen its compensation curtailed. From a management perspective, the company has to get back on a growth track or compensation will remain constrained.

While a deal with Linde might trigger a very beneficial change of control provision for Praxair current senior management, those that expect to stay with the company for the medium to long term will also benefit from having a much larger canvass to work with to create growth in the future. This may not be a great deal for PX shareholders in the near-term – depending on what PX has to pay (or give up) to get this deal done – but it may drive a much better 5-10-year story than a go-it-alone strategy would.

Our conclusions on the industry and the major players are as follows:

  • With slower global industrial growth, all of the companies are seeing more limited opportunities to deploy capital profitability and as the historic high cost providers (APD and Linde) get more efficient, incremental returns on new capital are unlikely to go back to historical peaks, especially for Praxair.
  • In the US, while an infrastructure program might be good for the packaged gas business – Air Liquide and PX – Air Liquide is likely to build some air separation facilities in the US to supply its packaged gas business, taking incremental business from PX and APD.
  • Today we see Air Liquide with the better stand-alone story and this is combined with relatively attractive valuation.
  • APD looks expensive, given that most of the easy restructuring wins are now behind the company – we remain unconvinced that APD will stand by and let PX acquire Linde without possibly making a bid also.
  • Whether or not PX is a buy or sell today depends on whether a deal with Linde can be done and on what terms – we still believe that PX will want some sort of control and that given the significant multiple difference between the companies today, Linde is likely the better way to play a prospective deal today especially if APD steps in.

Two further thoughts:

  1. With no details around deal structure, possible divestments, premiums, etc., it is hard and almost pointless to try and model a combined PX/Linde today. However, we can make some assumptions about the opportunity to be shared.
    1. Conservatively there is likely at least $1bn of synergies and another $1bn of possible improved margin at the combined company – assume that this is shared 50/50 and PX would gain as much as $2.50 per share – probably over 3 years, but possibly offset by some lost business in the US.
    2. Earnings for 2019 on a PX share basis could be closer to $9.00 than the current $7.00.
  2. Dow and Dupont share prices peaked on the rumor and fell on the deal announcement – it has taken a year and crude oil moving to the mid-50s to get back close to that “rumor” peak.
    1. The synergy flow through for both Dow and DuPont is well understood and estimates of possible cost opportunities keep rising – consequently we can make the same 2019 earnings argument as we have above for PX, but the market is not paying for it yet.
    2. With the regulatory uncertainty around a PX/Linde deal we doubt that PX’s share price would move dramatically quickly without much more clarity.

Growth

Whichever way you cut it, the Industrial Gas industry is slowing down – Exhibits 3 and 4. Even though there are only 4 major producers, as opportunities to deploy capital fall, competition to win the business rises and this has an overall negative effect on incremental returns on capital. Companies then have the choice of accepting this lower return or walking away from the business, reducing capex and perhaps buying back stock or increasing dividends instead. Yet the aggregate charts in Exhibit 5 show share repurchases have been deemphasized in recent years and dividend payments have stagnated.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

In the overview, we showed our estimate of the effect of lower capital spending on Praxair’s normal earnings – in Exhibit 6 we show the same chart for APD – same problem.

Exhibit 6

Source: Capital IQ, SSR Analysis

Compensation

Praxair has for many years elected to use a senior management compensation program aligned with what should matter to shareholders – EPS growth, return on capital growth etc. Furthermore, much of the compensation has been in stock grants and/or options. During the last decade, with capital deployment growing and returns on all capital growing, EPS growth was strong and management compensation reflected all of this. The architects of Praxair’s growth through that period, Dennis Reilley and Jim Sawyer, were well compensated based on these schemes, but if you look at PX’s share price through 2014 – Exhibit 7 – shareholders were equally well compensated. From January 2000 to January 2014, PX generated an average annual total shareholder return of 16%, and as shown in Exhibit 8, was best in class.

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

Praxair’s CEO’s 2015 compensation is summarized in Exhibit 9, taken from PX’s 2016 proxy. It shows the more limited compensation because of lack of growth. Praxair’s board of directors has tweaked the compensation metrics for 2016, by replacing the EPS growth driver with a 3-year relative (to the S&P500 ex financials) total shareholder return (TSR) metric. Given the recent move in the stock this may result in higher 2016 executive compensation than in 2015, but without growth, medium to long-term compensation will be constrained. A TSR based metric runs the risk of not delivering if lower growth results in further relative multiple deterioration – Exhibit 10. The announcement of a possible deal with Linde has reversed the recent trend in relative multiple – earnings are not the driver given that 2016 earnings are expected to decline 5% versus 2015.

Exhibit 9

Source: Company Reports, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

We would be disappointed if a deal with Linde resulted in an overhaul of what is currently a very shareholder friendly compensation plan and we think that such a move would be very unlikely. However, it would more than likely cause a reset of the “bars” with TSR and return on capital targets based off a merged base line. Linde’s return on capital is well below Praxair’s today and a merged entity would have some sort of average return on day one. If PX pays up for full control of Linde, then the initial combined return on capital would fall much further. We would expect the board of directors to set metrics based on a new level of pro-forma EPS or TSR and ROC, which would incent management to continue to run the combined entity as effectively as PX has been run thus far.

Praxair’s Chairman and CEO, Steve Angel, has been in the role for almost 10 years and while he is tipped to run a merged Praxair/Linde, we would expect this to be a short-term role pre-retirement. We would expect any PX/Linde deal to trigger a “change of control” at PX and this would be particularly beneficial to Mr. Angel, and in our view well deserved.

©2016, 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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