Air Products (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?
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.
Dividend Analysis: Air Products
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. APD’s long-term dividend and fundamental data charts can all be seen by clicking here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
APD has a Dividend Safety Score of 45, which suggests that its dividend safety is about average. The company’s earnings and free cash flow payout ratios are reasonable at 54% and 64%, respectively. As seen below, APD’s earnings payout ratio has increased by about 10% over the last decade but has generally remained stable.
However, we can see that its payout ratio spiked up in 2009, highlighting the cyclicality of the business. We would prefer APD’s payout ratio remain below 50% because of its sensitivity to the economy, but its situation could be much worse.
APD’s sales fell by 21% in 2009, and its free cash flow per share plunged by more than 50%. The company is obviously not resistant to recessions, and its stock returned a very disappointing -48% in 2008. This sensitivity lowers APD’s Dividend Safety Score.
However, regardless of business conditions, we can see that APD has generated very reliable returns on invested capital. Management claims that every capital investment of more than $3 million is reviewed at the corporate level and must meet a strict 10% internal rate of return. The company appears to be allocating capital reasonably effectively.
APD has generated free cash flow every year, which is great, but it’s been volatile. This is because the projects APD invests in are very expensive and lumpy – they take years to build before generating any meaningful amount of cash flow. We expect free cash flow to keep trending higher as the company’s productivity improvements are made.
Reviewing APD’s balance sheet is very important given the company’s cyclicality. APD says it is committed to maintaining a balance sheet that deserves an A credit rating, but it has more debt than we like to see. The company will use some of the proceeds from the Materials Technologies spin-off to reduce debt.
Overall, APD’s Dividend Safety Score is only about average because of the company’s cyclicality, high debt, and relatively high payout ratios (by our standards for a cyclical business).
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
APD has increased its dividend for 38 straight years and is a dividend aristocrat. The company has a Dividend Growth Score of 56, which suggests its dividend growth potential is about average.
It’s uncertain how APD’s current dividend will be split between its Materials Technologies spin-off and its industrial gases business. However, management has stated that the total amount of dividends will be the same and that the company will continue targeting a 2.5% to 3% yield.
As seen below, APD’s dividend has grown at a high-single digit rate over the last decade, although growth has slowed into the mid-single digits more recently. Until we have more clarity on the spin-off’s impact on the dividend, we expect no more than a mid-single digit growth rate going forward.
APD trades at 18x forward earnings and has a dividend yield of 2.5%, which is slightly lower than its five year average of 2.7%.
We believe this business can compound its earnings by 5-7% per year over the long term, resulting in a potential total return of 8-10% per year.
However, at 18x earnings and a dividend yield somewhat below its five-year average, we believe the stock is at least fairly valued today. We would be more interested in owning it below $120 per share.
APD is a durable business with numerous competitive advantages. We would be interested in owning this blue chip dividend stock at a better price, which would potentially be caused by a continued slowdown in global growth prospects.
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