Industrial Gases – Adapt to Slow Growth, or Underperform

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

December 3rd, 2015

Industrial Gases – Adapt to Slow Growth, or Underperform

  • Slow or no volume growth can hurt industry leaders more than the rest of the pack, particularly in consolidated industries
    • Praxair looks more at risk of underperformance in the Industrial Gas space than others because it’s options for countering slow growth are limited
  • If Air Liquide can integrate the Air Gas business well it will get growth levers unavailable to others
    • Others lose incremental volume; ARG moves supply to Air Liquide where practical
    • Marginal gains for others because of required divestments from the deal
    • A distracted AL/ARG may lose some near-term share
    • AL/ARG needs a well-articulated strategy to drive synergies and growth
  • APD will continue down its cost path, but will suffer from the same slow growth as PX and has decided to keep chasing lower return projects in China
    • Lack of other options to deploy capital is driving the China decision
    • These are higher risk investments given changes in Chinese growth drivers
  • Linde still has internal cost opportunities as margins have never reached the potential suggested by the BOC deal
  • The risk for the group is a re-rating: lower growth = lower multiple
    • Lack of options may lead to some “off-piste” acquisitions – not necessarily bad, but hard to sell to investors
  • Despite some attractive valuations, we would move underweight in this group. Air Liquide could be the better bet, but execution is everything, and not guaranteed

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

We like the market structure of the Industrial Gas space, and we have liked the efficiency focus at Praxair, which has driven considerable outperformance over the past decade. One of the key drivers of performance has been the operating leverage in air separation platform. These facilities have incremental margins well over 50% and volume growth has allowed companies like Praxair, with a focus on keeping costs low, to grow returns on capital over time, something hard to do in any manufacture industry.

But growth has dried up. The long term history shows a reasonable correlation between volume growth and US GDP or Industrial Production, but this is driven by the extreme values at the high and low end. The historical relationships are much less relevant in periods of middling growth – which we have been enduring since essentially the middle of the last decade – Exhibit 2.

Exhibit 2

Source: Capital IQ, SSR Analysis

This breakdown of the correlation is a function of a several things, but in our view a major component is the “experience curve” of the customer base, with different end markets improving processes and raw material efficiencies at different rates. In addition, an economy with less than 2.5% growth generally has some components in decline. For example, US steel production bounced off the low in 2009 and showed growth for 3 years, but has been in a slow decline ever since – Exhibit 3 – and that decline may accelerate without limits on Chinese steel imports in 2016. Praxair has greater metals exposure than APD globally and in the US, and this weakening market is a major headwind – Exhibit 4.

Exhibit 3

Source: Bloomberg, SSR Analysis

Exhibit 4

Source: Company Presentations, SSR Analysis

The industry is facing slower growth and with the significant asset base and continued high levels of investment (mostly outside the US), there has been a recent meaningful decline in asset productivity and return on capital. This from an industry that has generally managed to hold its own.

Without some sort of synchronized global economic recovery, the sector is at risk of a re-rating because of the declining top and bottom line growth, leaving companies with a few, not terribly attractive options

  • Cut costs and restructure where companies are not efficient – Linde and Air Products
  • Chase higher risk investments with potentially lower returns – Air Products (China)
  • Consolidate/M&A
    • Within the sector – Air Liquide/Airgas – integration and cost opportunities
    • Tangentially, given limits on market concentration.
  • Hunker down – buyback stock, raise the dividend and hope – Praxair (so far)

Over the last 3 years, only APD has had a more radical approach to the business – it shows in the relative performance – Exhibit 5.

Exhibit 5

Source: Capital IQ, SSR Analysis

If we look at valuation, and bearing in mind that our valuation models are less robust for the non-US companies, we do not see much to get excited about – Exhibit 6 – particularly when we consider that the historic models are driven by a growth rate that the industry is not seeing today and that relative multiples are falling – Exhibit 7 shows the history for PX with a 6 year negative trend, APD on the same trend until the activist stepped in and the recent boost that ARG has seen from the deal.

Exhibit 6

Source: Capital IQ, SSR Analysis

Exhibit 7

Source: Capital IQ, SSR Analysis

We have lost our enthusiasm for this group as the slower growth and potential for sub-par investments and hard to execute M&A, more than offset any valuation opportunities. A strong plan for Air Liquide, backed by the current Airgas management, coupled with an intelligent management structure for the US might give us confidence that what looks like an attractive value for Air Liquide is worth the bet. But we are not there yet!

Otherwise we think that this sector is potentially dead money for 2016, with a risk that destructive deals could drive downside.

Productivity Declining

Since the recession, industrial gas companies are simply not generating the same level of sales out of their assets – capital is being invested but the returns are not there. This comes after a long trend upwards during the prior decade (for PX and APD at least). Sales as a percentage of PP&E peaked in 2008 for these companies, plummeted in 2009, and never recovered, suggesting customers tightened up and learned how to do more with less product.

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

Using assets as a proxy for PP&E and looking at this regionally, the trends are similar across most regions, with South America the exception for PX. Changes in reporting structures and available data yield much shorter histories for ARG and the major European players.

Exhibit 12

Source: Capital IQ, SSR Analysis

Exhibit 13

Source: Capital IQ, SSR Analysis

Exhibit 14

Source: Capital IQ, SSR Analysis

Exhibit 15

Source: Capital IQ, SSR Analysis

Exhibit 16

Source: Capital IQ, SSR Analysis

Pricing Power

Pricing gains have taken a step down in recent years, across all geographies, suggesting overbuilt capacity and lack of demand growth – it is always harder to get a price increase from a customer who does not want more from you.

Exhibit 17

Source: Company Presentations, SSR Analysis

Exhibit 18

Source: Company Presentations, SSR Analysis

Exhibit 19

Source: Company Presentations, SSR Analysis

Cost Structures – How Much Is There to Cut

For PX and APD in particular, cost control has been a continuous focus. Linde and Air Liquide have engineering businesses that inflate their ratios. The other major difference is the major SG&A component of a packaged gas business. This also puts into context how low PX has driven costs given that it has a significant US packaged gas footprint and why APD can do much better (no packaged gas). There is huge cost opportunity for Air Liquide/Airgas in the US with the right approach.

Exhibit 20

Source: Capital IQ, SSR Analysis

Acquisition History Mixed

In earlier decades, PX performed exceptionally well after announcing and completing large deals (>$500 million), but did not fare as well following the recent NuCO2 acquisition. This may well be a function of limited growth.

Exhibit 21

Source: Capital IQ, SSR Analysis

APD had not made a (successfully completed) acquisition for more than $500 until the $950 million purchase of Indura in mid-2012 – the subsequent outperformance has more to do with activism as the company has written down much of the acquisition already suggesting an inflated price.

Exhibit 22

Source: Capital IQ, SSR Analysis

Valuation & Skepticism

We had previously assumed a plus-market multiple for Praxair (~1.1). Adjusting this to the company’s average multiple (based on normal earnings, relative the S&P) in its public history (0.92) and updating the return on capital trend to capture the recent downturn, we still have a cheap stock but less significantly so than previously.

Exhibit 23

Source: Capital IQ, SSR Analysis

PX is near an “optimism” extreme – given the state of returns, the stock could be a lot cheaper than it is, or alternatively, an improvement in earnings is already priced in.

Exhibit 24

Source: Capital IQ, SSR Analysis

Air Products has looked relatively expensive for some time, though recently returns have more than caught up. Forward estimates call for an average of 25% year over year net income growth for the next four quarters (Exhibit 27). We think this is aggressive given macro conditions and that the current valuation premium is vulnerable if the company falls short.

Exhibit 25

Source: Capital IQ, SSR Analysis

Exhibit 26

Source: Capital IQ, SSR Analysis

Exhibit 27

Source: Capital IQ, SSR Analysis

Exhibit 28

Exhibit 29

Source: Capital IQ, SSR Analysis

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