Published by Nick McCullum on October 21st, 2017
Air Products & Chemicals (APD) may not be the most well-known Dividend Aristocrat. The company is primarily a business-to-business manufacturer and distributor of industrial gases – an industry that does not have the same brand recognition of, say, Colgate-Palmolive (CL) or Procter & Gamble (PG).
However, the company is still an elite dividend stock. Air Products & Chemicals is a member of the exclusive Dividend Aristocrats list, a group of reliable dividend stocks with 25+ years of consecutive dividend increases.
Air Products & Chemicals’ dividend history – 35 years of consecutive dividend increases – indicates that the company is a model of consistency.
With that said, the company has reinvented itself over the past years. A spinoff and a separate significant divestiture were implemented with the goal of streamlining the company’s business model and focusing on its core industrial gas operations.
This article will analyze the investment prospects of Air Products & Chemicals in detail to determine whether the company holds appeal at current prices.
Air Products & Chemicals is one of the largest producer and distributor of atmospheric and process gasses in the world. The company’s customers include other businesses in the industrial, technology, energy, and materials sectors. Headquartered in Allentown, Pennsylvania, Air Products & Chemicals was founded in 1940 and has a current market capitalization of $33 billion.
The company has a significant international presence. Just 39% of consolidated sales were generated in the U.S. and Canada last year, with Europe being the second-largest geographical unit with a 27% sales contribution.
More details about the company’s business unit and geographic distribution can be seen in the following images.
Source: Air Products & Chemicals 2016 Annual Report, page 2
The past several years have seen Air Products and Chemicals focus on divesting non-core assets, streamlining its business model, and reducing overall costs. Since the company was featured in last year’s Dividend Aristocrats in Focus series, there have been two major transactions that have helped move the company’s streamlining initiatives forward.
First, Air Products & Chemicals completed the spinoff of its electronics materials division. The business unit now trades on the New York Stock Exchange as Versum Materials under the ticker VSM. Air Products & Chemicals shareholders received one share of Versum for every two shares of APD owned in a two-for-one stock dividend worth about $11.50/share of APD at the time of the spinoff. Shares of Versum have nearly doubled since the spinoff, indicating that management created significant shareholder value by offloading this business unit.
The second major transaction that Air Products & Chemicals has completed is the sale of its performance materials division to specialty-chemical manufacturer Evonik Industries AG for $3.8 billion in cash, which closed in January.
Together, the businesses that Air Products and Chemicals have sold over the past year generated about $2.0 billion in sales and nearly $530 million in EBIT in fiscal 2016. Today’s Air Products & Chemicals is a smaller, leaner enterprise and is well-situated to deliver satisfactory growth moving forward.
The streamlining initiatives undertaken by Air Products & Chemicals in the past several years (including those that were discussed in the last section) have led to significant profitability improvements for this industrial gas giant. The company’s EBITDA margin trend over the last several years can be seen below.
Source: Air Products & Chemicals Third Quarter Earnings Presentation, slide 14
Air Products & Chemicals has seen its EBITDA margin expand by approximately 900 basis points since the second quarter of 2014 – a significant improvement by any standard.
Looking ahead, Air Products and Chemicals is likely to deliver satisfactory growth for several reasons.
The first is a number of new worldwide manufacturing and distribution centers that will soon be in service. These include nitrogen plans in China, oxygen and nitrogen plants in India, and a liquifier plant in New York. Additional details about Air Products & Chemicals pipeline of major projects can be seen below.
Source: Air Products & Chemicals Third Quarter Earnings Presentation, slide 8
Air Products & Chemicals recent M&A activities have left the company with a significant cash cushion. At the end of the most recent quarter, the company reported cash and short-term investments of $3.3 billion – about 10% of its market capitalization and nearly 20% of its total asset base. The company plans to use these funds to acquire smaller industrial gas manufacturers, particularly in Asia. Management has also stated the desire to repurchase shares at appropriate prices.
So how fast can investors expect Air Products & Chemicals to grow moving forward?
Historically, Air Products & Chemicals has compounded its adjusted earnings-per-share at a rate of 8% per year. The company’s full earnings history can be seen below.
Source: Value Line
We believe that Air Products & Chemicals is likely to continue growing at a similar 6%-8% rate looking forward.
Competitive Advantage & Recession Performance
Air Products & Chemicals has a number of competitive advantages.
The first is industry expertise. The company employs a number of chemists and engineers with the technical know-how to successfully deliver projects on time and within budget. It would be difficult for a start-up company to compete with Air Products in the industrial gas distribution sector because of this.
Moreover, the industrial gas distribution business benefits from high switching costs. These costs may not necessarily be financial – instead, customers are unlikely to switch once their gas needs are being met by a particular supplier because it would be difficult to find a competitor that offers identical services in a particular geographic region. To that end, Air Products & Chemicals’ size also benefits the company.
The company’s recent divestitures and asset sales have given it an infusion of cash, bolstering its corporate finances in a way that should help it endure any upcoming economic downturns. Moreover, Air Products & Chemicals has a track record of performing resonably well during past recessions. Consider the company’s performance during the 2007-2009 financial crisis for evidence of this:
- 2006 adjusted earnings-per-share: $3.50
- 2007 adjusted earnings-per-share: $4.40
- 2008 adjusted earnings-per-share: $4.97
- 2009 adjusted earnings-per-share: $4.06
- 2010 adjusted earnings-per-share: $5.02
Air Products & Chemicals experienced an 18% decline in adjusted earnings-per-share during the 2007-2009 financial crisis, but the company’s bottom line surged to a new high water mark in the subsequent fiscal year. We expect a similar level of recession resiliency to be demonstrated during future periods of market turmoil.
Valuation & Expected Total Returns
As discussed previously, we believe that Air Products & Chemicals is likely to grow at a reasonable 6%-8% per year over full economic cycles. On the surface, earnings-per-share growth combined with the company’s 2.5% dividend yield gives Air Products & Chemicals the potential to deliver double-digit total returns.
This would be the case if the company’s valuation remained at its current level. Unfortunately, that is highly unlikely.
Air Products & Chemicals is expected to report adjusted earnings-per-share of $6.15 in fiscal 2017. It’s stock currently trades at $153.94 for a lofty price-to-earnings ratio of 25.0.
The following diagram compares Air Products & Chemicals’ current valuation to its long-term historical average.
Source: Value Line
Air Products & Chemicals current price-to-earnings ratio is 25.0 and its long-term average price-to-earnings ratio is 17.5. The company appears to be significantly overvalued at current prices. We recommend waiting for better opportunities to buy a stake in this high-quality business.
Air Products & Chemicals’ business transformation over the past year has de-risked its business model and allowed it to focus on its core business of industrial gases.
We welcome this change. Moreover, we’re happy with the company’s focus on emerging markets.
These positive factors cannot outway the significant premium that the market is placing on these shares. Valuation contraction will inhibit APD’s total returns moving forward, preventing us from issuing a buy recommendation.