Industrial Gases – Pricing Coming and Good for All

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

February 9th, 2015

Industrial Gases – Pricing Coming and Good for All

  • Air Products current valuation discounts earnings in 2016 and 2017 that exceed already high consensus estimates. This suggests that if APD management and active ownership aim to improve on current valuation, they must focus on moving faster than currently forecast by the sell side.
  • Cost cutting will continue to play a major role and we expect upwards of 2500 people to leave the APD workforce over the next 18-24 months, possibly more. But this will not be enough on its own and we see no option for APD other than to aggressively chase pricing at every opportunity.
  • Consensus already has APD revenues growing faster than PX from 2014 to 2017, reversing a 14 year average and unlikely explained by more heat exchanger sales and further improvements in the already very good materials business. PX has better gas assets, in better places and with better leverage, so any economic recovery will help PX more than APD in our view.
  • Consensus also has APD EBITDA and EBITDA margins growing more quickly than PX from 2014 to 2017, which is highly likely given APD’s ability to cut costs and PX’s inability given its already lean structure. However, unless the new CEO takes out 25% of the workforce this will not be enough – APD needs to earn more than $9.00 per share in calendar 2017 just to justify current valuations in our view (especially relative to PX) – let alone generate any upside.
  • If APD begins to push pricing hard, as contracts renew, others are likely to benefit as much or possibly more than APD. Others will likely be more ambitious on pricing themselves if APD is taking the lead and the heat. Additionally, APD will get some negotiations wrong (probably an acceptable proportion in their minds) and lose the business.
  • It is likely that if APD’s valuation is a correct reflection of the future, consensus estimates for all of the other gas companies could be too low. PX is the obvious valuation play here as expectations are very low, but Air Liquide also looks interesting on our base metrics.

Exhibit 1

Source: Capital IQ, Bloomberg, SSR Analysis

Overview

We expect that cost cutting alone will not be enough to lift APD’s earnings as much as is required to support the stock today, let alone generate further valuation upside. We estimate that the current value of the stock is discounting 2017 earnings that are around 10% higher than current consensus and that APD would need to see a path to $9.50-10.20 of earnings per share in the 2017/2018 time frame to support any further appreciation.

So far, since the change of leadership, Air Products has done very well:

  • The materials and electronics segments continue to grow both revenues and earnings above the company and above industry average.
  • The equipment business is also benefitting from North American investment in LNG export terminals.
  • Expense cutting helped fiscal Q4 2014, and headcount reduction further helped fiscal Q1 2015. We would expect the headcount reduction to continue.

However, the underlying gases business continues to disappoint and in our view does not have much upside going forward given the position of the asset base and some of the investment decisions taken prior to the change in management.

Furthermore, APD cannot sell anything accretively because nothing in the portfolio is worth more than the current 30+ multiple.

Cost cutting can take the company a long way, but to base the strategy on only one tactic is unrealistic and we would expect management to fully understand this. Consequently, we would expect APD to pull hard on the only other real lever available – pricing. Pricing is never a large component of growth in industrial gases because contracts are longer-term (sometimes greater than 10 years for large, anchor, on-site customers) and some pricing is derived on a cost pass through formula. However, a proportion of contracts come up for renewal every year and every year a proportion of the business gets re-priced – down if there is greater competition and up if there is limited or no competition. Even if pricing is renegotiated flat, often returns on capital increase because plants become more fully depreciated.

If APD takes an aggressive price leadership position, which we think is highly likely, others will do one of two things (given that growth is slow everywhere and results have been disappointing): they will follow where they can, and they will take share where they can. The trick for all is to work out the price at which your customer can find an alternative and set the increase just below that price – obviously the increase can be higher the greater the logistical constraint.

Any APD plan to push pricing will assume some lost business, with the idea that the price gains more than offset the volume lost. In such a situation, all players are likely to gain, resulting in faster earnings growth and positive surprises through 2015 and into 2016.

If APD is successful, its share price could continue to rise, but the leverage is in the cheaper, less loved U.S. names like PX (which looks cheap on our normalized framework – Exhibit 2) and ARG (which looks interesting on our SI screen given its much improved return on capital trend – Exhibit 3)

 

Exhibit 2

Source: Capital IQ, SSR Analysis

Exhibit 3

Source: Capital IQ, SSR Analysis

Reversal of Fortune

Air Products certainly trumped Praxair in 2014 in terms of growth in both revenue and EBITDA, going against the average performance of the last ten years – Exhibits 4 and 5. Praxair’s revenue shortfalls relative to APD were driven by poor results in Latin America and exchange rate weakness in the region, while APDs revenues were helped by continued strong growth in the materials and equipment business. On a like for like basis, APD continues to lag PX on a gasses growth basis.

The significant EBITDA gains at APD were a function of better margins in materials and equipment, but also the start of some significant cost moves under the helm of the new CEO, particularly over the last 6 months – in the charts below we compare calendar quarters to adjust for APD’s September year end.

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Looking at the forward numbers, we see a very different set of expectations than history would suggest – Exhibit 6. In our view the EBITDA side of the chart is easier to believe than the revenue piece. When thinking about revenue, we must remember the following:

  • Praxair has better industrial gas assets in better locations, with greater density, and marginally more exposure to the US than APD.
  • APD has capacity under construction that we believe will yield lower returns than the company has seen historically and lower returns than the under construction capital at PX.
  • APD cannot generate all of its gains relative to PX from materials and equipment – there is a limit to how many LNG facilities will be built and how much better the materials business can get.
  • On an apples to apples basis, we continue to believe that APD’s gases business will not grow top line as quickly as PX’s business – PX has greater leverage.

We will come back to revenue later in the discussion

Exhibit 6

Source: Capital IQ, SSR Analysis

Relative EBITDA gains are easier to understand, but they come down to APD’s ability to cut costs, whether they are short-term expenses (which played a big part in fiscal Q4 2014) or more permanent headcount reductions (which helped fiscal Q1 2015). There is a lot of cost that can be cut in our view. Even though APD has a similar SG&A/sales ratio compared to PX, the lack of a larger packaged gas business at APD suggests that SG&A/sales should be much lower than PX.

If, for a moment, we assume that APD’s revenue forecast is correct, some of the EBITDA gain from 2014 to 2017 will be a result of the new revenue. Over the last 12 years, APD has seen an incremental EBITDA margin of 29%, slightly higher than its current average. This gets you close to current consensus estimates for 2017, but still around $150m short, suggesting that APD will need to cut another 1000 or so people on a net basis. Note that this is on a revenue forecast that is probably too high – more to come!
But estimates for APD are not high enough!

If we assume that a lean/mean APD is worth the same as an already lean/mean PX, then we should probably see multiple convergence in the out years – we do not. Today PX is at 15.9x 2017 EPS estimates and APD is at 17.4x 2017 EPS estimates. Looking at consensus estimates, part of this is a function of flat or declining EBITDA margin assumptions for APD in 2016 and 2017 – Exhibit 7. APD needs to earn just over $9.00 in 2017 in our view to justify current valuation (relative to PX). This adds $225 million to required 2017 EBITDA and, without boosting revenue assumptions, would require another 1,500 to 2,000 lay-offs.

Exhibit 7

Source: Capital IQ, SSR Analysis

Revenues have to accelerate – so prices have to rise – so everyone wins

APD management and its more activist owners are not going to be interested in scraping their way to an EBITDA number that just supports the current value and be forced to get there through headcount reduction alone. With the cuts already made and the maximum numbers discussed above, we would get to as many as 3,500 people – roughly 16% of the current workforce. This is possible but would be very disruptive to business over a 1 to 2 year period.

APD needs more than one lever and the options are as flows:

  • Sell/spin materials – the business is valuable but not valuable enough to be an accretive sale and is currently most of the EPS and revenue growth at APD.
  • Sell/swap other assets – again the APD multiple is so high that it is not clear that any sale would make sense – some swaps might as any incremental gain in EBITDA would get the higher multiple.
  • Buy something big for equity – the equity value is very high – hard to make a dilutive deal on paper, but it is unlikely that the multiple would hold.
  • Raise prices aggressively, wherever possible.

We think that the last bullet is a no-brainer for APD and that every contract up for renewal will likely see APD push pricing much more aggressively than it has in the past. Most large volume and all pipeline sales in the industrial gas business tend to be long-term contracts – 5-10 years and longer for dedicated on-sites with

limited surrounding business. Given the age of APD’s portfolio we would guess that the company has 10-15% of its large contracts and any sized pipeline contracts up for renewal each year and the percentage may be higher in the US where the facilities are older.

If we are right we expect two positives for the rest of the group:

  1. APD leading pricing can allow others to follow without being the bad guy – “he is asking for 25% – we are only asking for 20%”!
  2. APD will lose some business around the edges – either because they calculate the customers’ alternative cost of supply incorrectly, or because thy cause a customer to shut down or relocate production, or because they annoy the customer so much that he or she moves business regardless of the cost.

From an investment perspective we would look at the situation the following way:

Either APD is too expensive and will start to disappoint its owners (rather than the sell side) quickly because it cannot generate the gains needed to support the stock – in which case you would rather own PX; or, APD starts pushing pricing and is successful, in which case APD could beat estimates and continue to do well, but PX will likely do much better as it is much cheaper – Exhibit 8

Exhibit 8

Source: Capital IQ, SSR Analysis

©2015, 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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