Air Products Is Poised for Rapid Growth

We think the market is missing

Air Products benefits from operating in an industry with a very favorable structure. Despite selling what are essentially commodities, public industrial gas companies have consistently delivered lucrative returns because of their economic moats. Industrial gases typically account for a relatively small fraction of customers’ costs but are a vital input to ensure uninterrupted production. As such, customers are often willing to pay a premium and sign long-term contracts to ensure their businesses run smoothly. Long-term contracts and high switching costs contribute to industrial gas producers’ moats, helping them generate a predictable cash flow stream and lucrative returns.

Demand for industrial gases is strongly correlated to industrial production, increasing at roughly 1.2-1.4 times global industrial production growth. As such, organic revenue growth will largely depend on global economic conditions. That said, we think Air Products can fuel additional revenue growth through mergers and acquisitions, asset buybacks, and new projects, especially in emerging markets such as China and India.

Since Seifi Ghasemi was appointed CEO in 2014, new management has launched several initiatives that drastically improved Air Products’ profitability, raising EBITDA margins by over 1,000 basis points. This remarkable improvement is largely due to significant cost cuts, divestments of low-margin noncore operations, and an aggressive pursuit of opportunities in emerging markets.

Air Products is poised for rapid growth over the next few years due to its roughly $15.4 billion capital-allocation plan. Management has a large amount of dry powder at its disposal as a result of cash proceeds from the Versum and Evonik divestments. The company has already spent $1.5 billion and committed another $6.4 billion, investing primarily in large gasification projects in emerging markets. Additionally, management is confident it will be able to invest roughly another $6 billion over the next five years via generating cash and raising additional debt. We think management’s plan is attainable and should fuel tremendous growth through 2022.

High Switching Costs Dig a Narrow Moat We assign Air Products a narrow moat rating, primarily due to switching costs and secondarily due to intangible assets. Air Products operates in an industry that is inherently moaty because of high switching costs. Although industrial gases are essentially commodities, they are a crucial input in many industries. Since gas typically represents only a fraction of total costs, customers are often willing to pay a premium and enter into long-term contracts with reputable distributors to ensure uninterrupted supply. As such, public industrial gas companies have historically earned returns in excess of their cost of capital, and we believe these lucrative profits will persist.

Industrial gases are distributed through three supply modes: on-site, merchant, and packaged. Operations are often tightly integrated across all three supply modes: An industrial gas company will build an on-site plant (either adjacent to a customer’s facility or connected through pipelines), and sell excess capacity through merchant (tanker trucks) and packaged (cylinders and dewars) supply channels.

Switching costs vary by supply mode. Packaged gases are essentially commodities without any switching costs. Merchant customers, on the other hand, do face switching costs, as they typically enter into three- to seven-year contracts and often rely on industrial gas companies for storage and vaporization. The on-site segment has the highest switching costs, because switching to another supplier might require a substantial cost to convert or purchase new equipment. Large customers often sign 10- to 20-year contracts with take-or-pay clauses and prices indexed to the cost of electricity, and we estimate that customer retention rates exceed 95%.

Air Products has a strong portfolio of on-site and merchant business. The former accounted for roughly half of the company’s fiscal 2018 revenue, while the latter contributed almost another 30%. Both segments support Air Products’ narrow moat, as they benefit from long-term contracts and high switching costs, and they have helped the company deliver roughly 13% average returns on invested capital since 2009, well above our estimated 8% cost of capital. We expect Air Products’ narrow moat will help the company continue to deliver attractive returns throughout the next decade.

We assign Air Products a positive moat trend rating due to management’s growing emphasis on on-site business (resulting in lengthening average customer contract terms, therefore enhancing switching costs) and a remarkable improvement in margins during Ghasemi’s tenure as CEO.

When Ghasemi took the helm in 2014, on-site accounted for 32% of Air Products’ revenue. Management has already increased the segment’s contribution to roughly 50% and indicated a desire to expand it to about 75% of sales over the next five years. We view this goal as attainable, considering that 90% of Air Products’ current $1.5 billion backlog is on-site or pipeline. Furthermore, management has already committed $6.4 billion of capital and is confident that it will be able to deploy roughly another $6 billion over the next five years, a large portion of which is expected to be on-site projects. Because the segment benefits from long-term customer contracts and high switching costs, we view the company’s commitment to the business as a positive trend for Air Products’ moat.

Furthermore, since Ghasemi was appointed CEO, Air Products has increased its EBITDA margin by over 1,000 basis points. New management divested low-margin noncore operations, spinning off its electronic materials division as Versum Materials in 2016 and selling its specialty additives business to Evonik in 2017. Moreover, the company launched a widespread restructuring in 2014 that resulted in significant cost cuts. Operating margins have improved from 17.4% in 2014 to 24.0% in fiscal 2018, and we forecast that margins will expand by about 100 basis points over the next few years.

Average Cyclicality, Meaningful Cash Flow Air Products has a medium uncertainty rating, as it exhibits an average degree of cyclicality. Demand for industrial gases is strongly correlated to global industrial production, so core volume growth will depend on the growth of the world economy. Furthermore, we forecast relatively high growth rates in China and India, which may not materialize if growth in those economies slows.

We expect limited upside in pricing in the industrial gas sector due to competition for new contracts, especially in emerging markets, and on-site customers' option to choose in-house production. Based on company reports and information published by Gasworld magazine, we estimate that roughly 30% of the global industrial gas market is captive (in-house production). We believe that competition for new contracts and the in-house production alternative will keep a lid on pricing over the long run, but we remain confident that Air Products' narrow moat will allow the company to keep delivering strong returns throughout the next decade.

Management has indicated that maintaining an investment-grade credit rating is a priority. The company has used proceeds from its recent divestments of noncore operations to reduce debt and fuel investment. The company held $3.5 billion of gross debt as of June 30, compared with $3 billion in cash and securities. Liquidity includes an undrawn $2.5 billion multicurrency revolving credit facility, which is also used to support a commercial paper program. Debt maturities during the next few years are reasonably well laddered and should not present any unusual problems, given the company’s access to the capital markets, as well as our expectation of meaningful free cash flow generation over our forecast horizon.

Stewardship Is Exemplary When he took the reins, Ghasemi unveiled his five-point plan to transform the company by focusing on safety, profitability, core business, a clean balance sheet, and at least 10% annual EPS growth. Thus far, management has delivered on all these promises. Over the last few years, the company has improved its employee lost-time injury rate by 75%, raised EBITDA margins by over 1,000 basis points, divested noncore segments, significantly reduced debt, and delivered average annual EPS growth of roughly 14%.

We believe management has been proactive about pursuing growth opportunities and appropriately managing its portfolio. The company deployed proceeds from divestments of noncore electronic materials and specialty additives divisions to reduce debt and fund investments. Then in 2018, Air Products acquired gasification businesses from Shell and GE, making it the global leader in this space. This positions Air Products to take advantage of future gasification opportunities in emerging markets such as China and India, which already make up a significant portion of the company’s backlog.