2024-01-12 07:30:00 ET
Summary
- I love buying world-class businesses when they are out of favor.
- Air Products and Chemicals’ lower cost of sales helped to offset lower sales in its fiscal fourth quarter.
- The company earns an A credit rating from S&P on a stable outlook.
- Shares of APD could be priced 3% below fair value.
- The company could meaningfully outperform the S&P 500 over the coming 10 years in my view.
In dividend investing, the formula for total return is quite simple: Dividends plus earnings growth plus valuation multiple expansion or minus valuation multiple contraction = total returns.
This formula is what makes buying great businesses at discounts to fair value my primary investing strategy. That is because, when a stock’s share price is beaten down, its starting dividend yield is higher. Not to mention that there is the potential for even more capital appreciation when a stock returns to its fair value. This is the essence of my investing strategy.
With its shares down 15% in the past 12 months, Air Products and Chemicals ( APD ) is one of my investment holdings that looks attractive. For the first time since last September , I will examine the company’s fundamentals and valuation to support the case for reiterating my buy rating.
Air Products & Chemicals’ 2.6% dividend yield is more than 100 basis points above the 1.5% yield of the S&P 500 ( SP500 ). What puts me at ease is that this dividend also looks to be sustainable and set to keep growing, just as it has for four decades and counting.
APD’s 61% EPS payout ratio is in line with the 60% EPS payout ratio that rating agencies view as safe for the industrial gases industry. Also, the company’s 36% debt-to-capital ratio is below the 40% debt-to-capital ratio that rating agencies prefer from the industry.
Owing partially to these factors, S&P rates APD’s debt an A on a stable outlook. That suggests the 30-year probability of bankruptcy is just 0.66% for the industrial gases giant.
For these reasons, it makes sense that the risk of APD reducing its dividend in the next average recession is just 0.5%. Even in the next severe recession, the chance of a cut remains subdued at 1.1%.
As I alluded to in the opening, APD isn’t just a superb business: Its shares appear to be undervalued. Based on the company’s historical dividend yield and P/E ratio, its shares could be fairly valued at $274 apiece. Relative to the current $265 share price (as of January 10, 2024), this implies that APD is trading 3% below fair value.
If the company were to revert to fair value and match the analyst growth consensus, these are the total returns that it could generate in the coming 10 years:
- 2.6% yield + 9.2% FactSet Research annual growth consensus + 0.3% annual valuation multiple upside = 12.1% annual total return potential or a 213% 10-year cumulative total return versus the 8.6% annual total return potential of the S&P or a 128% 10-year cumulative total return
The Fundamentals Are Intact
APD's financial results weren't perfect in its fiscal fourth quarter ended September 30, 2023. Overall, I was pleased, though. The company's sales dipped 10.6% year-over-year to $3.2 billion during the quarter. That came in $150 million behind the analyst consensus for the period.
A drop in the topline is something I don't like to see if there is no context that can account for such an event. However, there was a reasonable explanation for APD's results in the fourth quarter. The company's sales were down by double-digits, mostly because of a 14% decrease in pass-through energy costs during the quarter. In layman's terms, natural gas costs were considerably lower in Europe and the Americas, which were passed on to consumers. That more than offset the impact of 2% higher pricing throughout the business and a 1% foreign currency tailwind for the quarter.
APD's adjusted EPS surged 10.5% higher in the fourth quarter to $3.15. For perspective, this topped the analyst consensus by $0.04. The very same factor that led the company to miss the topline consensus helped it beat the bottom-line forecast. This is because lower natural gas costs resulted in a 15.8% decline in the company's cost of sales during the quarter to $2.2 billion. Thus, non-GAAP net profit margin expanded by 540 basis points to 21.7% for the quarter. APD's vast margin expansion explains how its adjusted EPS grew at a double-digit rate while sales contracted at a similar rate in the quarter.
Looking ahead, the company anticipates that it can continue to deliver double-digit adjusted EPS growth in fiscal year 2024. APD initiated fiscal year 2024 guidance of adjusted EPS between $12.80 and $13.10 - - midpoint growth of 12.5% over the $11.51 generated in fiscal year 2023. This isn't just blind optimism on the part of management, either. Last October, the company brought its natural gas to syngas facility online in Uzbekistan. That should be a major contributor to APD's earnings in fiscal year 2024.
Beyond that point, the company also predicts that its carbon capture and carbon dioxide treatment facility in Rotterdam, Netherlands, will be brought on-stream in 2026. Overall, APD has more than $19 billion in project backlog, with $15 billion focused on the energy transition, per CFO Melissa Schaeffer's opening remarks in the Q4 2023 earnings call .
Financial results and fundamentals aside, APD is also firing on all cylinders financially. The company's interest coverage ratio in fiscal year 2023 was 17.2. This suggests that APD can comfortably service its debt.
The Dividend Can Keep Compounding
APD's quarterly dividend per share has grown by 59.1% in the last five years to the current rate of $1.75 . If that weren't enough, I anticipate that the company's next dividend hike is just weeks away. For my money, it will probably be another 8% hike to around $1.89.
APD ran a free cash flow deficit of $1.4 billion in fiscal year 2023. However, I'm not worried that the company also paid $1.5 billion in dividends that it couldn't cover from free cash flow.
That's because, for APD, there are so many investment opportunities that make economic sense right now. For instance, capital expenditures have nearly doubled from $2.5 billion in fiscal year 2021 to $4.6 billion in fiscal year 2023 (details according to page 59 of 148 of APD's 10-K filing ). That's expected to grow even further to between $5 billion and $5.5 billion in fiscal year 2024.
APD can take on debt to pay its dividend and fund these growth projects. And as they come online in the years ahead, the company's free cash flow outlook should improve. If this weren't the case, APD wouldn't be on the cusp of delivering its 42nd consecutive annual dividend hike.
Risks To Consider
APD is a high-quality business, but it still faces risks that it must navigate and some risks that are at least somewhat beyond its control.
Just as I noted in my previous article, one of the bigger risks is the potential for projects to run longer than expected and go over budget. If this were to happen, it could impact APD's growth potential.
Another risk is that approximately 60% of APD's sales were to customers from outside of the U.S. That opens the company up to the risks of unfavorable foreign currency translation, evolving regulations in major markets, and potential tariffs or international sanctions.
Summary: A Sensibly Valued Dividend Aristocrat With Growth Tailwinds
If I didn't plan on being out of the market for at least a few more weeks due to building up liquidity, I'd be thinking of adding to APD here. It checks off every box that is important to me. Enticing starting dividend income? Yes. A savvy management team? I would answer in the affirmative. Robust growth potential? Absolutely.
To be clear, APD isn't the biggest bargain that can be found in the market today. This is a company that is executing about as close to flawlessly as is humanly possible, so it should be close to fully valued, as I believe it is currently. Overall, these reasons are why I am maintaining my buy rating.
For further details see:
Air Products and Chemicals: One Of My Favorite Holdings Is A Buy