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Air Products Posts Mixed Fiscal Q3 Results and Unveils Updated Capital Deployment PlanMorningstar's Analysis Air Products Posts Mixed Fiscal Q3 Results and Unveils Updated Capital Deployment Plan Krzysztof Smalec Equity Analyst Analyst Note | by Krzysztof Smalec Updated Aug 09, 2021 Narrow-moat rated Air Products reported mixed fiscal third-quarter results, as its sales of $2,605 million beat the FactSet consensus estimate of $2,498 million, but adjusted EPS of $2.31 fell $0.05 short of expectations. The industrial gas firm also lowered the top end of its full-year fiscal 2021 adjusted EPS guidance range by a nickel, from $8.95-$9.10 to $8.95-$9.05. We’ve trimmed our fair value estimate for Air Products to $316 from $323, which reflects our slightly more muted near-term projections and the implementation of a probability-weighted change in the U.S. statutory tax rate in our model. We see shares as modestly undervalued at current levels, with the stock trading in 4-star territory. Fiscal third-quarter sales increased 26% year over year and 4% sequentially, driven by a continued recovery in the firm’s end markets. We note that Air Products’ strong revenue growth reflects not merely a rebound from last year’s depressed levels due to the onset of COVID-19 but also solid 8% volume growth from prepandemic levels in the fiscal third quarter of 2019. Compared with the prior-year period, volumes grew in all regions: 6% in Asia, 9% in the Americas, and 24% in EMEA. Adjusted EBITDA increased 11% year over year, but the adjusted EBITDA margin compressed by 520 basis points, from 42.7% to 37.5%, due to a reduced contribution from Lu’An, higher costs, and higher energy pass-through (which increases revenue but not profits). Air Products unveiled its updated capital deployment plan and aims to deploy over $30 billion during the decade from fiscal 2018 through fiscal 2027. The company has already either spent or committed roughly $17.8 billion of that amount. Management said on the earnings call that of the remaining $12.2 billion, it expects to invest roughly $5 billion to support the existing business and the remainder in large growth projects, focusing on opportunities in gasification, green hydrogen, and carbon capture. Business Strategy and Outlook | by Krzysztof Smalec Updated Aug 09, 2021 Air Products benefits from operating in an industry with a very favorable structure. Despite selling industrial gases, which 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. As such, organic revenue growth will largely depend on global economic conditions. That said, we think Air Products can fuel additional revenue growth through 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 1,500 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 10-year capital allocation plan. The industrial gas firm aims to deploy over $30 billion during the decade from fiscal 2018 through fiscal 2027 and has already either spent or committed roughly $18 billion of that amount. We are bullish on Air Products' long-term prospects and think that the firm's ambitious capital allocation plan will fuel tremendous growth for many years to come, driven by investments in traditional industrial gas projects as well as new opportunities including gasification, green hydrogen, and carbon capture. Economic Moat | by Krzysztof Smalec Updated Aug 09, 2021 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. Finally, 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 52% of the company’s fiscal 2019 revenue, while the latter contributed another 44%. 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 12% average returns on invested capital since 2011, well above our estimated 8.6% cost of capital. We expect Air Products’ narrow moat will help the company continue to deliver attractive returns throughout the next decade. Fair Value and Profit Drivers | by Krzysztof Smalec Updated Aug 09, 2021 We are trimming our fair value estimate for Air Products to $316 from $323 after the company reported mixed fiscal third-quarter earnings. Air Products’ sales of $2,605 million beat the FactSet consensus estimate of $2,498 million, but adjusted EPS of $2.31 fell $0.05 short of expectations. The industrial gas firm also lowered the top end of its full-year fiscal 2021 adjusted EPS guidance range by a nickel, from $8.95-$9.10 to $8.95-$9.05. The fair value adjustment reflects our slightly more muted near-term projections and the implementation of a probability-weighted change in the U.S. statutory tax rate in our model. We are projecting average core sales growth of roughly 5.5% per year. Additionally, we assume that acquisitions and investments in large on-site projects will fuel strong growth over the next five years, as we expect management to deploy roughly $30 billion of capital during the 10-year period from fiscal 2018 to fiscal 2027. We project most of this growth to come from asset buybacks and investments in large on-site projects, with a focus on opportunities in gasification, green hydrogen, and carbon capture. Management has already aggressively reduced fixed costs, which led to adjusted operating margins growing from 16% in fiscal 2014 to 24.9% in fiscal 2020, marking a nearly 900-basis-point improvement during Seifi Ghasemi’s tenure as CEO. We are projecting an additional 150-basis-points of operating margin expansion to approximately 26.5% by fiscal 2025. Risk and Uncertainty | by Krzysztof Smalec Updated Aug 09, 2021 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 are forecasting 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 it to keep delivering strong returns throughout the next decade. Our medium uncertainty rating is not materially affected by environmental, social, and governance risks. We think the largest and potentially most material ESG risks for the company include potential product quality and safety failures and failure to comply with various environmental as well as health and safety laws. Capital Allocation | by Krzysztof Smalec Updated Feb 05, 2021 We assign Air Products an Exemplary capital allocation rating. The rating reflects our overall assessment of the company’s balance sheet, management’s investment decisions, and shareholder distributions. Air Products has a sound balance sheet and significant capacity to pursue growth by investing in new projects. We view management's investment history as exemplary, as Air Products has significantly improved its profitability and accelerated growth through its ambitious capital deployment plan in recent years. Lastly, we view the industrial gas firm's shareholder distributions as appropriate. In January 2021, Air Products increased its quarterly dividend by 12%, from $1.34 to $1.50, extending its dividend growth streak to 39 consecutive years. Since taking the helm in 2014, CEO Seifi Ghasemi has orchestrated a remarkable turnaround. When he took the reins of the company, Ghasemi unveiled his five-point plan to transform it 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 as Air Products has been firing on all cylinders. Over the last few years, the company has improved its employee lost-time injury rate by over 60%, raised EBITDA margins by over 1,500 basis points, divested noncore segments, significantly reduced debt, and delivered average annual EPS growth of roughly 11%. We believe Ghasemi 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 (Versum Materials in 2016 and Evonik in 2017) 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. |
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