2023-11-07 15:00:28 ET
Summary
- Air Products and Chemicals, Inc. shares plunged 10% after reporting disappointing quarterly results, raising concerns about the long-term growth story.
- The company's revenue fell by 10% to $3.2 billion, largely due to lower energy pass-through expenses.
- Weakness in China and slow recovery in the electronics market impacted the company's operating income in Asia.
- Its Louisiana Project will cost $2.5 billion, raising worries about the cost and returns on its $19.4 billion backlog.
Shares of Air Products and Chemicals, Inc. ( APD ) plunged 10% on Tuesday after reporting a disappointing set of quarterly results, turning shares negative over the past year. Shares have still returned 16% since I recommended the stock last October , but given these results, it is worth revisiting to see if the long-term growth story here is challenged. I do not share the market negativity, and I would be a buyer on this weakness.
In the company’s fiscal fourth quarter , APD earned adjusted EPS of $3.15, which beat estimated by $0.04. Revenue fell by 10% to $3.2 billion, largely due to lower energy pass-through expenses. In aggregate, volumes were flat, prices were a 2% tailwind, and energy pass-through was a 14% drag on revenue. However, it is critical to note that this energy pass-through is merely a cost recapture, not a driver of profits. As a consequence, EBITDA margins expanded 740bp to 39.5%, largely due to lower no-margin energy pass-through revenue.
Still, the lack of volume growth was definitely a disappointment and points to a slowing global economy. There was pretty meaningful divergence across the globe. In the Americas, operating income rose by 20% to $398 million thanks to 3% volume growth and 4% pricing growth, aided by strength in hydrogen. This is consistent with the U.S. having been an economic outperformer.
In the middle, Europe saw flat volumes and operating income rise 12% to $168 million due to weakness in merchant demand. Operating income rose 12% to $168 million, aided largely by currency.
The laggard was Asia, which saw a 7% drop in volume as China’s recovery remains slow, and electronics market demand has been soft. This pushed operating income down 25% as margins compressed 600bp. Weakness in China is something we have seen from a host of chemicals companies like Dow ( DOW ) and Eastman (EMN). This bears continued watching.
For the full year, volume growth was 3%, and EPS growth was 12% to $11.51. This was a solid result and shows the benefits of APD’s growing scale as it executes on its development pipeline. However with Q4 volume growth of 0%, results have slowed sequentially throughout the year. This could continue to be a headwind next year. Still, management provided 2024 guidance of $12.8-$13.10 in EPS, up 13% from last year. Q1 is expected to be just $3.00. Now, Q1 is seasonally softer, but this guidance implies a meaningful ramp throughout the year, and the market may be feeling somewhat cautious about the in-year growth occurring. Still, it is important to remember that APD has proven to consistently generate substantial growth.
Frankly, even if one feels EPS may be ~$0.25 aggressive due to the assumed in-year ramp, that would not lead to a 10+% stock decline in my view. Rather, the market is getting worried that APD’s growth projects are too ambitious and too costly. Management announced that the cost of its Louisiana blue hydrogen and carbon capture project has increased by $2.5 billion to $7 billion , with $1 billion of this due to inflation. Some of this cost increase though is due to increasing the ambitions of the project.
Management has said it will still generate a double-digit return on its investment in this plant, but given this cost increase, I think there is some skepticism about this. Still, even if we assumed this entire $2.5 billion is lost, that would be less than 4% of the market cap, and shares are down much more.
This is because Louisiana is just one of many expansion projects as APD seeks to meet the demand for cleaner energy. As you can see below, Air Products has many mega projects with a total cost of over $19 billion. If you assumed the same 40% overrun everywhere and that none of this can be recouped via higher prices, that is $8 billion in cost, which happens to roughly equal today’s market cap loss.
Suddenly, the market views Air Products’ growth ambitions as a liability rather than an asset. However, I think this drop is overdoing it. First, each project is somewhat different and at different stages of developments—cost overruns will not be constant. Additionally, some of the Louisiana cost increase is due to an increased scope, and APD should get a return on that investment.
There is also tremendous demand and government incentives for clean hydrogen and carbon capture, which should enable pricing gains to offset these price increases. Higher steel and labor costs are not unique to APD; they are raising production costs across the industry, which should provide a greater ability to pass it on. As you can see below, APD’s chemical spending has been ramping significant relative to a few years ago, with 2024 likely to be a new high.
APD retained $1.7 billion in cash flow after dividends for cap-ex in 2023. Based on its EPS guidance, this should be $1.9 billion this year. That means APD is using debt to finance some of its cap-ex, and the company estimates it has $30 billion in capacity over time. There is $1.6 billion in cash on the balance sheet against $9.3 billion in long-term debt from $6.4 billion a year ago. This is little debt relative to its market capitalization, but higher rates also make this capital spending more aggressive.
The Louisiana cost increase is a negative—this cannot be disputed. However, I think it is wrong for the market to assume APD cannot recoup any of this cost by negotiating higher prices for its products. It also is rather pessimistic to assume similar cost overruns everywhere. Management has proven to be able to deliver on its backlog in a shareholder-accretive way, steadily boosting cash flow and earnings.
After today’s drop, a lot of bad news is priced into Air Products and Chemicals, Inc. stock, and shares have a 5.6% distributable cash flow yield, using this year’s ~$3.1 billion. I believe the ongoing energy transition is a persistent theme, and I do not expect to see APD’s double-digit EPS growth rate materially slow. I still view its growth prospects as an asset, not a liability, and I would use this dip to buy into a strong and growing cash flow generative business. With $15 in 2024 DCF, I still view about $300 or a 5% DCF yield as fair value, and over time, I expect APD to recover today’s losses and more.
For further details see:
Air Products and Chemicals: Cost Overruns Scare The Market