The Rising Influence of Rising Affluence

[DewDiligence]

APD Makes Hefty Profits From Thin Air

[This piece is from today’s Barron’s. Please see #msg-46518659, #msg-53070399, and #msg-52106025 for related info.]

http://online.barrons.com/article/SB50001424052970203651904575437501490880646.html

›AUGUST 21, 2010
By JACQUELINE DOHERTY

The shares of Air Products & Chemicals should be floating upward right about now, carried by the gentle winds of the economic recovery.

Instead, they are grounded. They've barely budged since February, when the company, which produces oxygen, hydrogen and other gasses for industrial use, launched a $5.3 billion hostile bid for a rival. The fear among investors is that Air Products, like so many other acquirers, will go for the glory and overpay.

The company (ticker: APD), with a market value of $16 billion, insists that it will do no such thing—and that earnings will be strong with or without a deal for Airgas (ARG). CEO John McGlade tells Barron's that Air Products on a stand-alone basis should boost revenue by 10% to 12% annually over the next five years, with earnings climbing 12% to 14%. The company would have similar growth, but on greater business volume, with a sensibly priced acquisition of Airgas.

That sets up two possible ways for investors to win. If the bid–currently for $63.50 a share in cash–fails, or if it goes through at a price below $70, the stock could climb by as much as 20% over the next year. Anything over $70 would reduce earnings per share in 2011, putting pressure on Air Products stock.

If the economy picks up even a little more, demand for the company's wares should increase markedly. Oxygen is used by steel makers to improve efficiency and hydrogen is used by oil refiners to help produce cleaner fuel [see #msg-46518659 for elaboration]. In fact, industries ranging from food processing to semiconductor manufacturing use one or more of the company's gasses. So an upturn in those businesses would mean an immediate lift for Air Products.

The Allentown, Pa., company "is a great way to play cyclical growth," says Sarat Sethi, a portfolio manager at Douglas C. Lane & Associates, a New York City-based money manager. The shop owns both Air Products and another of the industry's best-run companies, Praxair (PX).

Air Products trades at 15 times calendar 2010 earnings, a discount to the 19 multiple that Praxair sports. Air Products' stock has risen only 2% since it unveiled its offer for Airgas in February, vastly underperforming Praxair's 18% return over the same period.

TABLE—Air Products ' stock is cheaper than those of rivals, and its earnings are growing nicely:

 
                       Recent   2010    2010  2011  2011   Div 
 Company/Ticker        Price   Revenue  EPS   EPS   P/E    Yield 
 Air Products (APD)    74.80     9.2    5.17  5.93   13    2.6% 
 Airgas (ARG)          66.18     4.1    3.13  3.64   18    1.5% 
 L'Air Liquide (AIQUY) 20.95    17.0    1.34  1.48   14    2.5% 
 Praxair (PX)          88.12    10.0    4.69  5.27   17    2.0%

Sources: Thomson Reuters; Bloomberg

For Paul Mann, an analyst with Morgan Stanley, the discount isn't warranted. It makes Air Products his favorite stock in the industrial-gas sector. He believes the shares are worth closer to $92, a target arrived at by using a typical, mid-cycle multiple of 16 on $5.75, his earnings per share estimate for the company's fiscal year ending September 2011.

"These stocks are probably more cyclical than people appreciate," says Mann.

Air Product's revenue–without any benefit from an Airgas acquisition —is expected to hit $9.1 billion in the current fiscal year, which is still short of the fiscal 2008 peak of $10.4 billion. Yet thanks to cost-cutting over the past year, operating margins in the most recent quarter were 16.6%, topping the historic peak of 15% in fiscal 2007.

About $750 million of the lost revenue should return over the next two years, and it will generate strong operating margins of 35% because it comes from existing plants with excess capacity, says Paul Huck, the company's chief financial officer. Additional revenue will come from new plants with lower operating margins as they come on line. In all, the company's operating margins are apt to come in at 17% or more in 2011 and higher in 2012.

Air Products divides its business among three major segments. Roughly a third of revenue comes from 15- to 20-year contracts, primarily in the company's "tonnage" gas segment. In these contracts, buyers agree to pay regardless of whether they accept delivery of the gas or not. In return for entering these contracts, Air Products builds a gas plant next to its client's operations, which are often steel plants or refineries. Plants can cost anywhere $50 million to more than $100 million.

The company also turns gas into liquid so that it can deliver the gas to smaller clients, typically using tanker trucks. [This business segment is called “merchant gasses.”] The third big division caters to the electronics industry, delivering products to semiconductor plants and the like. While the "tonnage" unit is the most stable, the electronics segment is the most volatile.

Airgas delivers its gas to clients yet another way: via cylinders sold through a network of stores or trucks. It's a type of operation that Air Products has internationally but not in the U.S. because it sold its packaged-gas business in 2002 to, ironically, Airgas. Airgas, which has grown through acquisitions, commands 25% of the U.S. packaged-gas market.

Airgas margins are historically 11% to 12%. "We think we can get them into the 16% to 17% range," says CFO Huck. Air Products forecasts $250 million of cost savings from the acquisition, and it can use its existing plants to provide some of the gas that Airgas sells.

Landing Airgas won't be easy. Its founder, CEO and Chairman Peter McCausland, 60, has been saying "no" since first approached privately by Air Products last fall. Airgas officials declined to be interviewed, but in regulatory filings call the offer "grossly inadequate." Airgas stock, the filing adds, has had "superior" returns—80% over the past five years, double that of Air Products' shares.

Air Products' current $63.50 a share offer is a 46% premium to the $43.53 where Airgas's stock stood before the offer became public in February. But Airgas' bankers, Goldman Sachs and Bank of America Merrill Lynch, have deemed the offer "inadequate." Airgas argues that its shares were depressed in February because of a punk economy and disappointing earnings.

Many Airgas shareholders aren't waiting to see how this saga plays out. Roughly 40% of its shares are now held by arbitrageurs with short-term bets on the merger. Shareholders are also signaling that they expect Air Products to up the ante—Airgas now trades around 66.

Air Products isn't blowing hot air. It increased its bid in July, nominated three directors for election in September to the Airgas board and recommended that its target's next annual meeting be held in January, so it can try to get another three directors on the nine-person board. It recently won clearance from the Federal Trade Commission to do the deal, if it sells certain assets.

Though a transaction could be scuttled by a white knight, the FTC clearance gives Air Products "a tremendous time advantage over any other buyer," says Jeffrey Cohen of Silverado Capital Management, an arbitrageur with Airgas shares.

As long as Air Products doesn't overpay, the stock should inflate nicely.‹