APD – Time to Move to the Sidelines – PX more Interesting

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 5th, 2014

APD – Time to Move to the Sidelines – PX more Interesting

  • APD has become too expensive in our view and now presents much more risk than reward given the lack of movement on the CEO front and the likelihood that possible improvements to the business model will take some time (several years) to materialize. We are unconvinced that the current shareholder base has the patience to wait for the improvements needed to generate further upside from here.
  • The stock is trading at close to a record forward earnings multiple and this has historically been a good time to exit. In our view, while first fiscal quarter earnings beat estimates, the quality was poor as the gas business disappointed. We see risk to fiscal Q2 earnings as a result.
  • At the same time, Praxair’s quiet underperformance sets up a pairs trade opportunity equivalent to the one we saw a year ago, but the other way around. To get back to a trend line in Exhibit 1 APD would need to fall by 15%, or PX rise by 20%.
  • PX has far more leverage to an improving US economy than APD and its strong position in Latin America, particularly Brazil, should also be a benefit. The near term risk for PX is that it has recently invested in Russia – though the exposure is limited. The other risk is that PX has greater calendar Q1 2014 weather related risk than APD because of US packaged gas.
  • The risk to shorting APD would be two-fold: first the recruitment committee hits a home run that we cannot foresee; second, they give up and APD offers itself up for sale either as a whole or in pieces.

Exhibit 1

Source: Capital IQ and SSR Analysis

Overview

The activist interest, some turnover of ownership and a reasonable, but not great set of fiscal Q1 results have driven APD’s share price above $120. At this point our alarm bells are ringing and, while we were more neutral on the stock when we wrote about activism last month, now we would be taking profits and putting our money elsewhere.

Two things drive this view – the first is that an awful lot of good is priced into the stock already, and we are not sure that good can come quickly enough to live up to investor expectations, and the second is what now appears to be a much better investment in Praxair.

APD is trading at 21x earnings estimates for 2014, which is close to the highest forward PE the company has seen and it has never seen it for long. The expectations in the stock are very high and in our view too high. There is anticipation about what new leadership can bring to the company, but we believe that meaningful changes at APD will take a long time, and that there is risk that we have an increasingly impatient shareholder base.

Note that we were disappointed with the quality of fiscal Q1 earnings. The overall numbers were good, but there was upside surprise in materials, electronics and equipment and the core gas business looked disappointing. It is not clear to us why these numbers were as weak as reported and while we expect materials and equipment to continue to do well, we see risk in the gases numbers for fiscal Q2.

At the same time Praxair has been underperforming the market, as the under-loading of its facilities facing both the European and US economies have been a drag on return on capital. That said, there is momentum in the US economy and while the ISM numbers this week showed a decline, they were very good in our view, given the severity of the winter. Given the size of its US packaged gas and merchant gas business, PX has far more leverage to a US recovery than APD and in our view will quickly move back to and probably above trend return on capital, which unlike APD’s is growing.

This time last year we highlighted the discount in APD’s value versus PX in one of our monthly reports – we were clearly not the only ones who noticed and it turned out to be a very good trade. Roll forward 12 months and the position is reversed – PX in the undervalued of the pair and in our view has the greatest potential.

We see very asymmetric risk reward here – operating leverage will make PX work, while valuation provides considerable support. APD, by contrast has no valuation support and lots of risk. The valuation spread was summarized in Exhibit 1

What is next at APD?

We wait patiently for a new CEO to be announced at APD. What does that mean, given that that we have been waiting more than 6 months?

  • All the obvious good candidates have said no – or have said yes but want too much money
  • The search committee had had to widen its net and therefore there is a risk that the new CEO is not greeted with applause, but instead a fast study to find out more about him or her.
  • A new CEO will be announced coincident with this publication – Murphy’s Law.

We believe there is real risk that either we see a candidate that the market applauds, but the pay package is high enough to be dilutive, or we get a candidate that is given an initial discount in valuation because benefit of the doubt is not warranted.

APD has some big problems to solve:

  • The company needs a coherent strategy that can guide behavior, goal setting and compensation discussions for many years. We have talked about too many changes of direction in past research and this needs to stop if the company has any chance of improving its returns on capital and getting the most out of its assets.
  • Based on the business the company has won and lost over the last five years and the results of its competitors, it looks like APD is not competitive in the design, construction and operation of basic air separation plants any more (others appear to have seen efficiency gains much greater than APD) – this has to be corrected.
  • Lack of density in the US means that APD cannot catch PX from a return on capital perspective in this business – the focus needs to be on getting as much out of these assets as possible and probably trading or selling some assets, where they are worth more to others.
  • We are also concerned that the large scale investments in China and the UK might be dilutive to returns in the near-term and this is not accurately reflected in estimates. In Exhibit 2 we show margins for the gasses business – merchant and tonnage for the last couple of years. The Q1 declines in gasses were not major, but they were going in the wrong direction. PX’s EBIT margins rose slightly in 2013, APD’s margins in gasses fell slightly.

Exhibit 2

Source: Company Reports and SSR Analysis

The business is for the most part a collection of 10-15 year contracts and consequently change will be slow – pricing can only be addressed when contracts come up for renewal and that is infrequent.

Not only will this take time, but the argument that APD’s margins and returns could be improved to reflect those at PX does not, in our view, hold water, and should not be used as basis for valuation. These companies are now very different and the right question is “how much of the gap can APD close?”

The big risk here is that new investors lose patience. We can see a scenario where a new CEO comes in and is possibly not someone overly familiar with APD. There will then be a period of several months of due diligence before we get anything concrete about the strategy and opportunities going forward. The company can do some cosmetic asset swaps round the edges, but at its current multiple almost anything it tries to sell will be dilutive.

In the meantime the stock is relatively expensive – not on our “normalized value metric” – Exhibit 3, but on a forward PE – Exhibit 4.

Separately, the average target price on the street is $111, but the average recommendation is neutral but on the cusp of a buy, so either target prices go up, which will likely result in inflated earnings estimates – or we get some downgrades.

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Meanwhile, PX has been losing ground and now looks like the much better bet

PX has underperformed the market for the last three years, best illustrated by the steady rise in its discount from normal value as shown in Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

The underperformance is coincident with a negative swing in return on capital which began in 2011 – Exhibit 6 – partly because of the weakness in Europe, but also because of stagnant or very slow manufacturing growth in the US. PX has significant leverage to the US manufacturing sector because of its significant position in the US merchant and packaged gas business. As we see the US manufacturing sector recover we should expect to see strong earnings growth from PX. In Exhibit 6 there is a recent upturn in the return on capital line, which we see as a good sign.

Exhibit 6

Source: Capital IQ and SSR Analysis

The bull case for PX would come from looking at the shorter trend line in return on capital in Exhibit 6. This line begins when the current management approach to the business began and it is the one we use in our models. PX has significant leverage in its US and European assets and it is not too much of a stretch to get to the upper line. This would be a current trend ROC of 13.2%. This generates current “normal earnings” of around $7.40 per share and a fair value of around $150 per share.

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