Air Products & Chemicals, Inc. (NYSE:APD) has rewarded shareholders with 38 consecutive years of dividend increases and is in the process of spinning off a non-core business to create further value.
This industrial gas business shares many competitive advantages with other stocks we own in our Top 20 Dividend Stocks portfolio, but is now the time to buy it?
At the end of September, a total of 77 funds from the Insider Monkey database held shares of APD, having amassed 28.50% of the company’s outstanding stock. Among them, billionaire activist Bill Ackman’s Pershing Square held 20.55 million shares, according to its last 13F filing. In the current round of 13F filings, Jim Simons’ Renaissance Technologies reported holding 855,800 shares of APD, as of the end of December.
APD was founded in 1940 and has grown to be a world-leading industrial gas company. APD provides atmospheric and process gases and related equipment to manufacturing markets, including refining and petrochemical, metals, electronics, and food and beverage. The business is also very international – sales in North America accounted for just 42% of APD’s total revenue last year.
The company is in the process of spinning off its Materials Technologies business by September 2016. This business accounted for 21% of APD’s sales last year and serves the semiconductor, polyurethanes, cleaning and coatings, and adhesives industries. After the spin-off, APD will be focused completely on industrial gases.
Industrial gases are a commodity, which means that the lowest cost provider usually wins out. However, as we noted in our analysis of Praxair, industrial gas providers actually have strong moats in their areas of service.
Gases are hard to ship. For example, liquid oxygen put in a tanker will evaporate after 200 miles. As a result, industrial gas is a local business with competition limited to a radius no greater than a couple hundred miles.
Furthermore, APD has long-term contracts and relationships with many customers, making it challenging for new entrants to crack into its markets. Start-up costs are also very high (large manufacturing plants take around three years to construct), and there are many technical regulations that must be complied with.
Industrial gas companies are also attractive businesses because most of their products use a very cheap raw material – air. Even better, gas typically accounts for just a small portion of a customer’s total manufacturing costs and is a non-discretionary expense, creating pricing power for APD. The industry is also characterized by a very slow pace of change, resulting in less risk of disruption.
APD is also taking self-help measures to improve its operations, in large part driven by pressure from an activist investor in 2013 and a new CEO starting in 2014. The company launched a strategic Five Point Plan two years ago that is intended to help it achieve its stated goal of being the most profitable industrial gas company in the world.
The plan’s key points are to focus on the core industrial gas business (APD is spinning off its Materials Technologies business); restructure the company (APD embarked on its largest organizational restructuring ever last year); improve the company’s culture; better control capital and costs (APD targets $300 million in operational cost savings over the next four years); and create better incentive systems at the business unit level.
APD’s actions are working – the company recently reported its highest quarterly operating margin in over 25 years. However, the company still has several risks to consider.
Air Products’ Key Risks
APD’s business is sensitive to the economy. When global economic growth slows and commodity prices drop, fewer metals need to be manufactured, demand for chemicals drops, and gas and oil refining activity slows.
APD is also the world’s largest supplier of hydrogen gases, which accounted for about 20% of sales last year and will be closer to 25% of total revenue after the Materials Technologies spin-off is completed. Hydrogen is used by refiners to facilitate the conversion of heavy crude feedstock and lower the sulfur content of gasoline and diesel fuels. The plunge in oil prices will likely have some impact on APD’s hydrogen business.
With the majority of its sales taking place overseas, APD’s near-term results are also impacted by currency fluctuations. Altogether, the risk is that many of the growth drivers for industrial gases are heading the wrong way and could persist for quite some time.
If growth prospects remain low, bidding for incremental projects could intensify. If conditions became really bad, some customers in industries plagued by excess capacity could see their credit conditions deteriorate.
If some customers cancel projects or are unable to make full payments to APD, the company could run into some cash flow problems because of its low cash balance ($279 million) relative to its debt on hand ($4.3 billion) and dividend commitments (about $700 million). This is a very low probability type of risk, but it shows the potential dangers of a highly geared balance sheet.