2023-11-10 09:44:04 ET
Summary
- LIN, the largest industrial gas company globally, demonstrated strength in its pricing power and cost management, leading to margin expansion and EPS growth.
- Despite facing macroeconomic headwinds, LIN's superior EBITDA margin and pricing power advantage position it well against its peers.
- While LIN's revenue declined, its effective pricing strategy and cost control allowed for operating profit and EPS growth in the third quarter.
Summary
Readers may find my previous coverage via this link. My previous rating was a buy, as I believed Linde plc ( LIN ), being the largest industrial gas company globally, was able to establish a presence in multiple end markets. I am reiterating my buy rating for LIN as they clearly demonstrated their strength as the largest industrial gas company globally. Although revenue in the quarter fell by just a little, its operating margins and EPS grew due to its effective pricing action and cost management. Revenue decline was clearly offset by margin expansion, thus leading to EPS growth. This clearly demonstrates its pricing power in the industrial gas market.
Comments
In the third quarter of 2023, LIN's revenue came in at $8.2 billion and was down 1% sequentially and 7% from the previous year, while cost pass-through was 6% lower than the previous year. Additionally, the engineering business shrank 1% sequentially and 4% from the previous year. Volumes fell 2% year over year and were flat sequentially. Since customer output declined in direct proportion to the level of industrial activity in their local economy, the volume decline is primarily due to the fact that current contractual customers need fewer gas refills. Management stated that they expect volumes to recover in line with the local economy. From this, it's a tell-tale sign that LIN and its end clients have been facing macroeconomic challenges such as high inflation and a rising interest rate, which have exerted pressure on its top line. When inflation and interest rates will come down is up to anyone's guess. As long as it stays elevated, it will continue to put pressure on LIN's clients and ultimately on LIN's revenue.
On a year-to-date basis, revenue came in at $24.5 billion, down 3.5% when compared with the previous year's same period. Although revenue was down slightly, its operating profit of $5.9 billion represents a margin of 24.4%. This is an improvement when compared with 2022. In 2022, operating profit was 3.6 billion, or 14.4%. This represents an improvement of 10%, which in my opinion is extremely impressive given the fact that they are operating in a challenging macroeconomic landscape plagued by high inflation and interest rates, which dampen overall economic growth.
However, on a brighter note, its $ 2.3 billion operating profit was up 1% sequentially and 15% over the previous year. Price actions, cost productivity, and fixed payment contracts allowed for greater leverage from the underlying 3% sales growth, resulting in an operating margin expansion of 5.5% to 28.3%. All business segments saw a 4% increase in operating margins when cost pass-through was excluded, with EMEA leading the way at 6%. As they continue to meet the stated target of double-digit percent EPS growth, EPS of $3.63 increased 17%. In my opinion, although LIN is facing pressure on its revenue, it excels at keeping its costs under control. Its effective pricing and cost control allowed it to expand its margins. With margin expansion more than offsetting revenue decline, it is able to grow its EPS by 17%, which is an impressive feat.
Moving onto the LIN's outlook, the first half of 2024 should show signs of recovery, in my opinion, as demand for AI grows and inventory levels level off, which should drive demand for industrial gases. One might ask how demand for AI drives demand for industrial gases. Gases like helium, argon, and nitrogen are crucial in the manufacturing of electronics, semiconductors, and sensors. As demand for AI increases, demand for such components also increases. As a direct result, demand for industrial gases will also increase in order to meet the demand to produce these parts. As LIN stated, they see the recovery in Gulf Coast hydrogen pipeline volumes, which has continued into the fourth quarter, and the stability of U.S. packaged gas volumes at a high watermark. Overall, I believe these tailwinds will continue to bolster demand for LIN's products. On the other hand, because of the weaker economic environment, metals end market volumes are slightly lower. However, weaker base volumes were more than offset by higher prices and growth from the contractual project backlog. The U.S. economy is expected to continue to perform at higher levels heading into the fourth quarter, with growth in almost all end markets predicted to occur both annually and sequentially. Electronic volumes are predicted to stay flat, while manufacturing, chemical, and energy end markets may exhibit a slight recovery. China's volumes are predicted to stay flat. In terms of Europe, LIN has not yet witnessed a turning point. Therefore, it is anticipated that volumes will remain at roughly third quarter levels, with a typical seasonal impact. Based on these tailwinds, management guidance for 2023 is positive, which signals confidence. It guided adjusted EPS in the range of $14 to $14.1, which represents an increase of ~15% when compared to 2022.
Valuation
Based on my view of the business, I anticipate a 4% growth in LIN's revenue for FY23, followed by 6% growth for FY24. This projection is lower than 2022's growth is largely influenced by the current challenging macroeconomic condition LIN is operating in, where inflation and interest rates are both high. However, moving into the future, I expect these headwinds to recover and put less pressure on LIN. Since the beginning of 2023, inflation has been steadily coming down. This resulted in the FED's less hawkish stance on interest rates, which has a major impact on economic growth. Despite facing challenges on revenue due to macroeconomic headwinds, LIN excels in its pricing and cost management, which resulted in margin expansion as well as EPS growth in the third quarter. I expect this strength to trend forward into the future as LIN clearly demonstrated its pricing power competitive advantage.
Based on author's own math
Peers overview:
Factset
In my opinion, these two companies are considered close peers of LIN. Those investors who follow LIN also closely follow these companies. This information is extracted based on seeking Alpha's related stock page.
LIN now trades at ~32x P/E, which is below peers' median of 33.66x. In terms of EBITDA margin, LIN's 36% margin dominates its peer's median of 19%, as it is almost double that of them. This really shows LIN's pricing power advantage and cost management, which I will discuss below. In terms of growth outlook, LIN's 4% for FY23 is slightly behind the peer's median of 7%. However, given the fact that its margin is clearly superior to that of its peers, I argue that LIN's P/E should be trading closer to its peers' higher end of the range. At 37x, my price target suggests an upside of 15%. Given these, I maintain my buy rating for LIN.
Based on the following chart that shows the historical P/E of all 3 stocks, it is clear that all of them are trading near their historical long-term average. In fact, for LIN, its P/E fell from its historical average around June 2023. From a peer valuation perspective, peers' median P/E seems reasonable as there are no outliers that might heavily skew the median into overvalued or undervalued scenarios.
Risk & conclusion
One downside risk to my buy rating is definitely the uncertainty surrounding inflation and the interest rate. If inflation were to take a sudden turn, it would prompt central banks around the world to turn hawkish in a bid to combat it. In such a scenario, LIN, which is a provider of industrial gas, will see its revenue facing pressure as its products are heavily reliant on economic growth.
As the biggest industrial gas provider in the world, LIN has managed to make a name for itself in several end markets. In the third quarter of 2023, its effective pricing strategy and cost control allowed operating margins and EPS to grow despite a slight decline in revenue. Due to its size and dominance in the gas sector, it clearly demonstrated its pricing power. Although LIN is operating in challenging market conditions, it has the ability to pass costs down to end clients. Moving ahead, the economy is expected to be less harsh as compared to 2023, as inflation has been cooling off since the start of 2023, and this is expected to provide relief on LIN's top line moving forward. On top of that, its superior EBITDA margin against peers makes it a better-quality company. On the back of these, I maintain my buy rating for LIN.
For further details see:
Linde plc Q3: Top Line Pressured By Macroeconomic Weakness But Bottom Line Expanded