2023-12-11 01:19:14 ET
Summary
- Air Products and Chemicals is a mature company with a well-diversified business model and the ability to benefit from emerging trends like hydrogen and liquid natural gas.
- APD has a two-pillar strategy, focusing on its existing business of core industrial gases and emerging growth in blue and green hydrogen.
- The company's recent earnings show strong performance, with double-digit earnings per share growth, improved margins, and successful execution of major projects.
Introduction
On December 6, I wrote an article titled Plug Power: Going Concern Warning and Policy Risks - Why I Was So Wrong.
Plug Power ( PLUG ) was my attempt to find a very small player with a potentially very high upside in the hydrogen space. Boy, was I wrong!
If there's one thing I learned from it, it's that I need to stick to what works, which is finding larger companies with proven track records of operating resilience and shareholder distributions.
Although these companies may have less room to rise than (successful) micro- to small-cap stocks, they come with a much better risk profile.
That's where Air Products and Chemicals ( APD ) comes in, a company I have covered multiple times in the past. My most recent article was written on August 16.
Air Products and Chemicals is special, as it combines a massive existing asset base with impressive innovative capabilities in markets like hydrogen and liquid natural gas ("LNG"), two industries that, I believe, have a bright future.
The company has been in business for more than 80 years. It serves more than 30 industries, employs roughly 23 thousand people in more than 50 nations, and services more than 750 production facilities with its supplies and knowledge.
It also has a dividend history of more than 40 consecutive hikes, making it a dividend aristocrat.
In this article, I'll update my bull case and discuss why I believe in APD's ability to deliver high, consistent shareholder value for many more years to come.
Buying Both Value And Growth
I like to classify myself as a buyer of assets that come with both value and growth. Companies in this category often have proven business models and the ability to reward shareholders through dividends and/or buybacks.
However, they are not too mature, meaning there's enough growth left to provide investors with a great total return picture consisting of dividends and potential capital gains.
Air Products and Chemicals is such a company, as it has a very mature and well-diversified business yet the ability to benefit from a number of emerging trends, like hydrogen and liquid natural gas.
USD in Million | 2022 | Weight | 2023 | Weight |
---|---|---|---|---|
Industrial Gases - Americas | 5,369 | 42.3 % | 5,369 | 42.6 % |
Industrial Gases - Asia | 3,143 | 24.8 % | 3,216 | 25.5 % |
Industrial Gases - Europe | 3,086 | 24.3 % | 2,963 | 23.5 % |
Corporate and Other | 971 | 7.6 % | 889 | 7.1 % |
Industrial Gases - Middle East and India | 130 | 1.0 % | 163 | 1.3 % |
Essentially, the company has a two-pillar strategy.
- Its existing business of core industrial gases.
- Emerging growth in blue and green hydrogen.
Many smaller companies do not have that benefit. Startups, for example, need to borrow heavily and rely on high-risk projects to grow their business.
Over the past ten years, APD shares have returned more than 230%, beating the S&P 500, which benefited from significant technology exposure during this period.
A part of its total return comes from its dividend.
Currently, APD shares yield 2.7%. Although this may not be the most juicy yield on the market, it has many benefits.
For example, protected by a 54% 2024E earnings payout ratio, its five-year CAGR is 10.0%, and it has hiked its dividend for more than 40 consecutive years.
As we can see below, consistent dividend growth was backed by consistent earnings per share growth. Since 2014, the company has grown its earnings per share by 11%.
These numbers are very impressive, especially given how mature APD is. In general, I'm always a bit careful when dealing with dividend aristocrats and dividend kings, as mature business models so often come with slow growth.
How Air Products and Chemicals Is Growing
Returning to its business model, the company focuses on on-site business with long-term contracts, which generates stable cash flow. Additionally, the company has achieved success in blue and green hydrogen projects.
The company's backlog of over $19 billion puts it in a good position for future double-digit earnings per share growth.
The most recent earnings are a great example of this.
- The fourth-quarter adjusted earnings of $3.15 per share exceeded guidance, showing an 11% improvement over the previous year.
- The full-year fiscal 2023 adjusted earnings per share of $11.51 reflect a 12% increase over the prior year.
Looking at the company's biggest segment, the Americas, we see that merchant prices improved by 10%. Volumes grew by 3% due to strong demand for hydrogen.
EBITDA increased over $600 million (up 17%), driven by pricing, volume, and equity affiliate income.
The EBITDA margin jumped over 1,100 basis points to 44.5%. Sequentially, EBITDA increased by 6%, mainly due to better hydrogen volume.
A big part of the company's success is not only caused by strong demand but also the company's ability to execute well.
During its fourth-quarter earnings call, significant progress in capital deployment was noted, with completed projects like Jazan Phase II, Gulf Coast Ammonia, and Jiutai.
The natural gas-to-syngas facility in Uzbekistan is operational.
Looking at the overview below, we see a more in-depth overview of major projects, including the blue hydrogen and blue ammonia clean energy complex in Louisiana.
The company is also working on the largest blue hydrogen project in Europe, developed with Porthos. Air Products will build, own, and operate the carbon capture and CO2 treatment facility, supplying low-carbon hydrogen to Exxon Mobil ( XOM ) under a long-term agreement. The project is expected to be on stream in 2026.
Furthermore, despite economic challenges, the company is optimistic about its future, as the capital deployment strategy and strong business model are expected to sustain a double-digit average earnings growth rate.
Moreover, the adjusted earnings per share guidance for fiscal year 2024 is in the range of $12.80 to $13.10 per share, reflecting a 13% increase at the midpoint over the previous year.
As one can imagine, working on massive projects is expensive. Very expensive.
I already briefly mentioned it, but currently, the company boasts a backlog exceeding $19 billion.
Notably, around $15 billion of this backlog is allocated to projects specifically aligned with the energy transition. This deliberate focus reflects Air Products' strategic alignment with sustainable and forward-looking endeavors.
Having said that, the company is not generating free cash flow. This year, free cash flow is expected to be negative $1.0 billion, followed by a deficit of almost $900 million in 2025.
The good news is that after 2025, the company is expected to be free cash flow positive again. It is also expected to absorb higher debt requirements without hurting its credit rating of A.
To give you an example of how efficiently APD is using its balance sheet to pave the road for future growth with expensive mega projects:
- In 2019, APD had less than $1.0 billion in net debt. Back then, it was roughly 0.3x EBITDA.
- In the 2024 fiscal year, APD is expected to end up with $10.4 billion in net debt. The net leverage ratio is expected to be 2.0x EBITDA. Despite the massive net debt surge, the leverage ratio is still healthy.
- In 2026, expectations are that net debt will be close to $14 billion with a 2.0x leverage ratio.
In other words, the company is on a path to more sustainable growth despite annual CapEx of more than $5 billion.
That is truly impressive and great news for its shareholders.
So, what about the valuation?
Valuation
Using the data in the chart below:
- APD is currently trading at a blended P/E ratio of 22.3x.
- This year (FY2024), EPS is expected to grow by 13% (in line with company guidance), followed by 10% expected growth in 2025 and a potential rise to 14% growth in 2026.
- The long-term normalized valuation is 19.8x earnings. Since 2018, the company has consistently traded above that as investors are pricing in high, consistent growth on a long-term basis. Given my view on the company's expansion, I agree with that.
- Hence, I believe that a 21.5x multiple is more appropriate.
- If the company were to maintain this valuation, it could return >12% per year through FY2026 and likely beyond.
- Since 2003, APD shares have returned 11% per year, including dividends.
While this is a theoretical valuation and by no means a guarantee, I do like the long-term value APD brings to the table and believe that APD is a great buy on stock market weakness.
Takeaway
As a dividend aristocrat with a mature yet diversified business model, APD navigates the delicate balance between value and growth.
Noteworthy achievements in blue and green hydrogen, coupled with a $19 billion backlog, signal future double-digit earnings growth.
Despite near-term negative cash flows, APD's disciplined financial management and sustainable leverage ratios set the stage for robust shareholder returns, making it an appealing investment in the evolving market landscape.
For further details see:
Undervalued Air Products and Chemicals Offers A Fantastic Mix Of Growth And Value