Published on January 31st by Bob Ciura
Every year, we review all the Dividend Aristocrats. There were two recent additions to the Dividend Aristocrats, including industrial giant Praxair (PX).
On January 25th, Praxair increased its dividend by 5%. This marked the 25th consecutive year of dividend growth for the company, meaning Praxair is officially the newest Dividend Aristocrat.
The Dividend Aristocrats are a select group of 53 stocks in the S&P 500, with 25+ years of consecutive dividend increases.
In order to become a Dividend Aristocrat, a company needs a strong business model, durable competitive advantages, and the ability to withstand recessions.
Simply becoming a Dividend Aristocrat is a huge achievement. But a long history of dividend increases is not the only important investment consideration.
Praxair is a high-quality company, but the stock appears to be overvalued.
Praxair was incorporated in 1988, under the name Union Carbide Industrial Gases Inc. Today, it is one of the largest industrial gas companies in the world. It generates annual sales above $11 billion, and has a market capitalization of approximately $46.6 billion. Nearly half of annual revenue is derived from outside North America.
Source: Morgan Stanley Global Chemicals and AG Conference, page 3
Praxair produces, sells, and distributes atmospheric, process, and specialty gases, along with high-performance surface coatings. Gases sold primarily include acetylene, helium, nitrogen, argon, hydrogen, oxygen, carbon dioxide, and more.
The coatings business provides surface protection for equipment and materials. Surface coatings help reduce the effects of abrasion, oxidation, corrosion, erosion, wear, and extreme heat.
Customers come from a variety of industries, including aerospace, chemicals, food and beverage, electronics, energy, healthcare, manufacturing, metals, and more.
Praxair has generated impressive growth over the past year. In 2017, Praxair generated adjusted earnings-per-share of $5.83, up 7% from the previous year. Revenue increased 11% for the year, while free cash flow soared 32% and reached a new company record.
Growth occurred across all geographic regions. In the fourth quarter, currency-neutral revenue increased 9%, 5%, 4%, and 14% in North America, Europe, South America, and Asia.
As a highly profitable company that generates excess cash flow, Praxair has the financial resources to invest in future growth. One way it does this, is through acquisition. For example, on June 1st, 2017, Praxair announced an agreement to acquire Linde, an industrial gases company based in Germany.
Source: Morgan Stanley Global Chemicals and AG Conference, page 14
This is a huge deal—Praxair agreed to pay approximately $35.2 billion for Linde. But the rewards are clear. The acquisition would propel Praxair to become one of the largest industrial gases company in the world, while surpassing top U.S. rival Air Products & Chemicals (APD). The combined entity would have annual revenue above $29 billion.
Broadly speaking, Praxair’s strategy is to combine its operational efficiency, with Linde’s technological platform and engineering prowess. It also provides a more balanced and diverse global portfolio. And, Praxair expects $1.2 billion in annual cost synergies from the Linde acquisition.
Competitive Advantages & Recession Performance
Praxair’s most important competitive advantage is its industry position. Retaining global scale is key to its high margins, and strong cash flow. With a global footprint, it would be extremely difficult for a new competitor to enter the market and take share from Praxair.
Praxair generates over $1 billion in annual free cash flow, which allows it to invest in growth initiatives such as acquisitions. In turn, this allows Praxair to retain its top position in the industry, and continue to grow.
As an industrial, Praxair operates in a cyclical sector of the economy. Its customers typically increase or decrease capital investment, based on economic conditions. This means Praxair is not a highly recession-resistant company. Earnings-per-share during the Great Recession are below:
- 2007 earnings-per-share of $3.62
- 2008 earnings-per-share of $4.19 (16% increase)
- 2009 earnings-per-share of $4.01 (4.3% decline)
- 2010 earnings-per-share of $3.84 (4.2% decline)
As you can see, Praxair fared well in 2008, but earnings-per-share declined the following two years. The good news is, the company grew steadily in the years after the Great Recession.
Valuation & Expected Returns
Praxair is a strong company, with future growth potential. However, the stock does not appear to be undervalued. Using 2017 earnings-per-share, Praxair stock trades for a price-to-earnings ratio of 28.1, which is above the S&P 500 Index average. It is also significantly above its own valuation over the past decade.
In the past 10 years, Roper held an average price-to-earnings ratio of 20.4. As a result, the stock is valued at a premium of approximately 27%, to its average price-to-earnings ratio in the past 10 years.
As you can see in the above chart, Praxair’s valuation multiple rose significantly over the past few years. A significant contraction of the price-to-earnings ratio, toward its 10-year average valuation for example, would represent a significant reduction of annual returns.
The company is still likely to generate returns moving forward, from earnings growth and dividends. ValueLine analysts expect the company to grow earnings-per-share by 11% in 2018. Achieving double-digit total returns each year is attainable for Praxair, particularly if the Linde acquisition closes.
Even if investors make relatively cautious assumptions about future growth, Praxair can generate satisfactory total returns. A potential breakdown of future returns is as follows:
- 6%-8% revenue growth
- 1% margin expansion
- 2% dividend yield
In this scenario, total returns would reach approximately 9% to 11% per year. Returns could be even higher than this estimate, if Praxair generates particularly strong earnings growth moving forward.
However, a contracting valuation multiple would reduce these returns. For example, a reasonable fair value estimate for Praxair could be a price-to-earnings ratio of 22 to 24, slightly above its 10-year average valuation.
With a price-to-earnings ratio of 22 to 24, Praxair stock would have a fair value estimate of $128 to $140, approximately 14% to 21% below the current share price. This indicates Praxair is overvalued.
Praxair continues to grow, as a beneficiary of the steady economic climate. Global economic growth continues, particularly in emerging markets such as China. Going forward, the company has the potential for continued growth, due in large part to the pending Linde acquisition.
At the same time, Praxair does not appear to be undervalued. It is an attractive dividend growth stock, thanks to 25 consecutive years of dividend increases and a 2% dividend yield. But value investors should wait for a better buying opportunity.