Description

Overview

The high-level thesis for Air Products (APD) is relatively straightforward:

• APD operates in an industrial gas oligopoly.

• The base business provides stable cash flows, a function of contractual revenue from on-customer-site infrastructure coupled with reliable and localized supply in the merchant side of the business.

• They have a proven ability to pass through commodity cost increases.

• Bright futures for hydrogen as a clean fuel, gasification and carbon capture provide meaningful positive skewness to the APD investment return profile.

• Management have shown strong execution and are thoughtful stewards of capital. The CEO has significant stock ownership.

• The balance sheet is secure.

• APD retains about 40-45% of earnings (and more like 50% of cash flow) to drive growth and pays the rest as dividends.

• We pencil a high teens IRR over five years (over $600 per share plus dividends), with higher probabilities above that range than below it. If hydrogen plays out as hoped, elevated returns could keep coming for decades.

There are only a handful of players with the technical chops, existing infrastructure, and global scale to compete in industrial gases and go after hydrogen, gasification, and related carbon capture in a meaningful way. These include APD, L’Air Liquide, Linde, and Messer. This rational oligopoly has historically provided for stability and pricing power that remains evident today.

Note the company has a September fiscal year. All references to years are fiscal (meaning, 2022 refers to the fiscal year ended September 2022) unless otherwise noted.

The Business

APD produces atmospheric gases (oxygen, nitrogen, and argon), process gases (hydrogen, helium, carbon dioxide, carbon monoxide and syngas, which is a mixture of carbon monoxide and hydrogen) and specialty gases. Atmospheric gases (47% of sales) are produced through air separation processes, with cryogenic being the most common. Process gases (22% of sales) are produced through other methods, like steam methane reforming or gasification.

About 52% of APD’s revenue is supplied “on-site,” meaning APD will build or acquire an on-site plant adjacent to a customer’s facilities or will connect to the customer facility through pipelines. These are typically delivered under 15- to 20-year contracts with limited volume risk and energy and raw material pass-throughs. Products include hydrogen, nitrogen, oxygen, carbon monoxide and syngas.

Around 40% of APD’s revenue is supplied through “merchant” channels. Most of this is liquid bulk that is sold under 3- to 5-year contracts using local supply chains. These gases are often drawn from excess capacity from on-site customers and are distributed using tanker trucks or tube trailers. The rest is packaged gas that is sold under short-term contracts. These are typically sold in cylinders and dewars, primarily in Europe, Asia, and Latin America.

Equipment and services make up the remaining 8% of the revenue base. This includes cryogenic and gas processing equipment for air separation, as well as an LNG equipment business.

In addition, APD has invested in many JVs, the most significant of which are in Saudi Arabia, Mexico, Italy, and India (which is the #1 player in industrial gases in India). APD is building and will operate some of the new multi-billion-dollar hydrogen and gasification projects through JVs. For instance, the new Jazan JV in Saudi Arabia is the largest from an invested capital perspective. Jazan will require a $12B total investment once completed (with fully committed financing), including 60% non-recourse project financing. APD will contribute $2.4B in equity for a 51% stake. Jazan supplies Saudi Aramco’s large refinery and power grid with power, steam, utilities, and hydrogen in exchange for a monthly fee under a 25-year contract.

End market applications for industrial gases are broad. In 2021, 23% of sales went to energy (79% of which was for refineries), 23% to chemicals, 17% to electronics, 14% to metals, 11% to manufacturing and the rest into medical, food and other. To name a few of the bigger ones:

• Refiners use hydrogen to convert heavy crude feedstock and lower sulfur content of gasoline and diesel.

• Chemical manufacturers use many different gases as feedstocks for many basic chemicals.

• Energy production uses nitrogen to recover oil and gas and oxygen for gasification.

• Oxygen is used for combustion and heating in producing steel, other metals, glass, and cement.

Major operating costs include electricity (for atmospheric gases), natural gas (for steam methane reformers) and liquid and solid hydrocarbons (for gasification and truck fuel). APD mitigates these exposures through contractual pricing formulas, surcharges and cost pass-through and tolling arrangements.

APD claims to have a roughly 15% global market share in industrial gases, with strength in hydrogen (where they claim to be the world’s biggest), oxygen, nitrogen, and helium. Most gases are produced at or near the point of use given the difficulties with storing gases at low temperatures. As such, APD has a large footprint of manufacturing and distribution locations (450 in Americas, 250 in Asia, 200 in Europe and 15 in Middle East and India).

As mentioned, L’Air Liquide, Linde and Messer are the major competitors (customers produce a lot of industrial gases in-house as well).

Management

Management is solid. Here is a slide from their investor deck on shareholder value that captures their philosophy well:

Management incentives are reasonable. Annual cash bonuses are driven by EPS, while long-term comp is 60% performance shares based on 3-year total shareholder return, and 40% restricted stock. Per the proxy, the CEO owns 533k shares of stock and 290k options/RSUs that vest in the near-term. The common stock alone is worth nearly $170M at current prices.

The Chairman and CEO, Seifi Ghasemi, is a focused operator and thoughtful capital allocator. He leads a team that is people-focused with an attention to culture. For instance, Ghasemi said he met with 2,000 employees during June and July to share the company’s strategy, answer questions and gather input. He planned to talk to all 20,000 employees in small groups over the course of the following year. He has shown his management principles in every quarterly slide deck since becoming CEO in 2014. His principles have guided him well, as he has overseen a period of dramatic operational improvement. He oversaw significant cost cuts and divestment of lower margin non-core businesses (electronic materials Versum in 2016 and specialty additives Evonik in 2017). This is consistent with his prior position leading Rockwell, which he focused on lithium through noncore divestitures and then sold to Albemarle for a nice premium and a 30% ongoing stake in the combined business. He also aggressively positioned APD for growth in emerging markets like China, India, and Saudi Arabia. In 2018 he announced a plan to invest over $30B over a 10-year period ending in 2027, which has since increased to $36.5B. Ghasemi targeted 10% annual EPS growth when he took over as CEO. Over the past eight years he has delivered 11% EPS and 10% dividend growth (now 40 consecutive years of dividend growth), with excellent stability:

Along the way, Ghasemi significantly improved APD’s balance sheet, which now sits at 1x net debt to EBITDA (this includes related party debt from JVs where APD is on the hook). They target staying within an A/A2 debt rating (which would allow for up to 3x leverage).

It’s worth noting that Ghasemi does not like to buy back stock. He views buybacks as a way to juice EPS in the short-term, without creating true long-term value. He believes the shares would need to be significantly cheaper for a buyback to result in better economics for shareholders vs. deploying it into organic growth like building new facilities. As he said on the Q4 call, “Now Air Products has entered a new phase of our company's evolution, in which we expect a steady stream of meaningful contribution from these new projects going forward and for years to come. By choosing capital deployment over share buyback, we believe that we have traded quick gains in the near-term for greater reward in the future.”

Business Quality

While industrial gases are a commodity, customers are often willing to lock in long-term contracts at premium pricing to make sure they have continued access. This is because industrial gases are critical to their operations but are a small fraction of overall costs. Reliability of supply is therefore at least as important as cost.

As discussed, about half of APD’s revenues come from long-term take-or-pay contracts based on equipment that is located on-site or piped into customer facilities. The customer typically provides the inputs for gas production from their facility and APD uses its integrated equipment to produce the desired gas output for a fixed fee. These revenues are sticky due to contractual terms and the high cost for customers to switch providers.

While more vulnerable than the on-site business, the merchant business also generates solid returns as customers typically enter multi-year contracts and rely on APD for on-site storage and vaporization. The strength of the merchant business is evident in the pricing power that APD has displayed this past year by passing through increased input costs without a hitch (though it can operate on a bit of a lag and requires some forecasting to capture well).

APD’s deep expertise in industrial gases and its global scale of operations (including significant pipeline infrastructure) make for a high barrier. For instance, APD can leverage its existing investment in hydrogen pipelines to build new environmentally friendly hydrogen facilities that would be uneconomic without the pre-existing pipes.

The quality of APD’s business is most apparent in capital deployed and return measures. Sales growth and margins are a red herring due to the large amount of pass-through revenue relating to commodity cost changes as well as price changes in the merchant business made in reaction to commodity cost changes. The significance of JVs to APD’s results further complicates the accounting. We therefore focus on growth in capital deployed to gauge business growth, and ROIC to gauge profitability.  

Management’s stated hurdle is to generate at least $0.10 of after-tax unlevered profit for every dollar of investment, or a 10% after-tax unlevered ROI. Some of these projects are riskier than others, as many are based on long-term fixed fee contracts while others include end market demand risk. Management does not give specifics around how much of a new project’s capacity is locked up in long-term contracts prior to investment, but management seems thoughtful around this and does not risk investor capital lightly.

The proof is in the pudding. APD has produced an attractive and stable ROIC (pretax) of around 18-20% since 2017, with 12% annual growth in capital deployed. They have accomplished this result despite holding significant amounts of cash needed to fund committed projects. This has resulted in a stable 15-17% ROE (after-tax). These figures likely understate the magnitude of the true returns as maintenance capex tends to run at less than half of depreciation expense. This dynamic results in part from GAAP depreciation guidelines, under which APD depreciates production assets associated with long-term supply contracts in line with the underlying contract term. In addition, there are projects in development that have driven up invested capital without contributing any profit (yet).

Growth

Management’s growth strategy centers on providing solutions for the world’s energy and environmental challenges through gasification, carbon capture and clean hydrogen. APD has developed core expertise in these areas. In 2018, management laid out a plan to invest over $30B (including project-related and other debt at 3x EBITDA) into these growth areas over ten years and have since increased the bogey to $36.5B. They have spent $11B so far and have close to $16B remaining in backlog. This leaves approximately $10B yet to be committed between now and 2027. Here are the major committed projects in the pipeline:

Gasification

Gasification is a way to make syngas from coal, high sulfur liquids or natural gas. Customers use syngas to make chemicals, diesel fuel, high-end olefins, or power. This technology has been used since the 1800s. It’s adaptable to various hydrocarbon feedstocks, including high-sulfur coal. There are no smog-causing particulates and the carbon dioxide it produces is concentrated in a capture-ready stream. It has a low operating cost and becomes more economical on a relative basis as oil prices increase relative to coal or gas.

Gasification is appealing to countries with large coal resources (like China, Indonesia, South Africa, and India) or natural gas reserves (like the US, Algeria and Uzbekistan) that would like to reduce dependence on imported oil to produce liquid fuel and high-end chemicals. In addition, it provides refineries around the world with a use for high sulfur bottom-of-the-barrel liquids that can no longer be used as fuel for ships post the IMO 2020 maritime law change.

Coal is far and away the feedstock leader for gasification processes in use today, followed by petroleum, gas, and others. This is not surprising given the abundance and cheapness of coal in many countries that lack access to other domestic hydrocarbon resources (like China and India). Chemicals are the largest end-use application, followed by liquid fuels, power and gaseous fuels (with the latter set to grow considerably through planned projects).

APD became the global leader in gasification in 2018, when it acquired Shell’s and GE’s technologies. Shell’s dry feed IP has been used to build over 200 gasifiers since the 1950s and has 120 currently in operation, with a focus on bottom-of-the-barrel refinery applications. The coal-water slurry feed IP from GE (formerly Texaco) is in even more widespread use, with nearly 300 gasifiers operating or under construction. After these two technologies, there are a handful of smaller players like Lurgi, ECUST, SEDIN and Siemens.

Carbon Capture

Carbon capture opportunities exist primarily in gasifiers and hydrogen plants, whereby carbon dioxide is removed and stored, typically belowground. Furthermore, the 45Q tax credit (which was recently increased through the Inflation Reduction Act) should provide a meaningful windfall to APD given how much carbon it already sequesters and plans to sequester as part of previously agreed projects (like the Louisiana blue hydrogen facility – see below). Under the new law, the US offers a tax credit of $85 per ton for carbon dioxide sequestration. Other countries may follow suit.

Hydrogen

As Thijs van de Graaf of the IMF recently said, “If the 1990s were the decade of wind, the 2000s the decade of solar, and the 2010s the decade of batteries, the 2020s could launch us toward a next frontier of the energy transition: hydrogen” (https://www.imf.org/en/Publications/fandd/issues/2022/12/hydrogen-decade-van-de-graaf). Hydrogen opportunities for APD are primarily in production and distribution as well as developing global infrastructure to support new applications (like trucking and bus transit).

Unlike oil and gas, hydrogen is manufactured and can be produced anywhere there is electricity and water. Hydrogen has several important characteristics that give it great potential as an environmentally friendly fuel during and after the energy transition away from dirty fuels. For one, it is abundant (though isolating it is tricky) and can be stored indefinitely in tanks and salt caverns. For another, it’s combustible. That means it can power engines and replace fossil fuel gas used for heat in manufacturing. Finally, it is transportable via pipeline and across oceans as it can be liquified or shipped as ammonia. Ammonia, a common ingredient in fertilizer, is produced by combining hydrogen with nitrogen (both of which APD produces). It is easily produced, shipped, and then cracked back into hydrogen at the point of use. This allows for global transportation of hydrogen.

Hydrogen has several applications that look most promising. These include production of steel, power generation and heavy transportation (large trucks, buses, airplanes, ships, and trains). For instance, steel production is a heavily polluting process where iron ore is melted in a blast furnace with coke (a coal derivative) or charcoal to extract oxygen and leave pure metal. In “direct reduction of iron” (DRI) process, hydrogen can remove oxygen from solid iron ore with much less heat intensity. In transportation, hydrogen has appeal over battery electric for heavy transport mainly due to the prohibitive weight of batteries. Another application is to use hydrogen to convert triglycerides into diesel (renewable diesel refineries require 4-5x as much hydrogen as a conventional refinery per barrel of production).

As per the International Energy Agency (IEA), industry represents the biggest growth opportunity, followed by grid injection and power:

In essence, anything that can be well-serviced by electricity (passenger cars, HVAC, cooking, lighting, etc.) will likely not be a good candidate for hydrogen. But all the heavier stuff (heavy transportation, industry, etc.) is.

There are currently three main ways to produce hydrogen.

• The traditional method is to mix natural gas (mainly methane) with steam to cause the carbon to separate from the hydrogen. Because this method produces significant carbon dioxide, it is not considered especially useful for the clean energy transition. This is called “gray hydrogen,” and it’s traditionally been used primarily for refining fossil fuels and manufacturing metals.

• The second method is to produce gray hydrogen but capture and store the carbon. This is called “blue hydrogen.” Blue hydrogen can be done with only 5% of the carbon dioxide emissions of gray hydrogen. This is accomplished by using autothermal reforming (ATR), instead of the traditional steam methane reforming (SMR). ATRs enable carbon dioxide produced in the processing of natural gas to be captured as steam, which allows for easy carbon dioxide capture. In an SMR, by contrast, half of the carbon dioxide is released into the atmosphere as flue gas and is not easily captured.

• The last method is to use an electrolyzer, whereby hydrogen is separated from oxygen in water by running an electric current between catalyst-played electrodes. This method produces no emissions directly, and if the fuel source used to power the process comes from renewable sources (like wind, solar, hydro, or geothermal), it is especially clean. This is called “green hydrogen.”

All three types of hydrogen are indistinguishable from each other once produced (they are all just fungible hydrogen molecules). The differences are only in the fuel and process required to produce them, and therefore their carbon intensity (around 12-13 kg of carbon per kg of gray hydrogen, 2.5-3 kg for blue hydrogen and 0.4 kg for green hydrogen, per management) and cost. These carbon differentials will translate to value differences in the marketplace as users will pay more for the lower carbon products (for instance, in the US customers receive carbon credits for purchasing green and blue hydrogen). As scale economies grow and technology improves, analysts expect the cost of green hydrogen to drop from $5/kg towards $1/kg, even without subsidies. This would make it competitive with gray hydrogen. As per Nature:

A brief and balanced video overview of hydrogen from DW Planet A can be found here: https://www.youtube.com/watch?v=AGTjKJHu99c. A brief and balanced written overview of hydrogen from Nature can be found here: https://www.nature.com/articles/d41586-022-03699-0, and here: https://www.nature.com/articles/d41586-022-03693-6.

A good example of APD’s hydrogen plans is the facility they are building in Louisiana. The facility will produce hydrogen from natural gas with permanent carbon capture. APD will ship the blue hydrogen through its 700-mile Gulf Coast pipeline and export it as ammonia via ship. The total investment will be $4.5B and it will be the largest carbon capture for sequestration facility in the world when it is completed in 2026. The 5M tons per year of planned carbon capture alone would produce $425M a year in tax credits for 12 years from 45Q (though note that unlike a fixed fee tolling arrangement, APD will have to buy its inputs like natural gas and electricity and therefore incur significant operating costs estimated around $200 per ton).

APD has announced several other large hydrogen projects that are in various stages of buildout. Some of these larger projects are long-term fixed fee take-or-pay (such as the $2.5B sustainable aviation fuel project with World Energy first announced in Q2 2022), and therefore have a largely knowable return profile. For others, APD is (purposefully) taking pricing risk on the ultimate value of the green or blue hydrogen they will produce (such as Louisiana). For these, the return profile is more speculative but also has significantly greater upside potential. The disclosures around these individual projects are pretty good and more detail can be found in the company’s slide decks and conference calls.

APD is in a great position to take advantage of the hydrogen future, and they have been the most aggressive of their peers in going after the opportunity, as the Louisiana project shows. APD claims to be the global leader in gray hydrogen today. After executing their Canada and Louisiana projects, they will also be the global leader in blue hydrogen. And after executing the NEOM project, they will be the global leader in green hydrogen. The NEOM JV, in Saudi Arabia, will require a $5B investment ($3.7B from APD). This project will produce hydrogen from wind and solar power to be used locally and shipped as ammonia. APD will make a $2B investment to fund hydrogen refueling stations for buses and trucks (which APD will control 100%).

Broadly speaking, hydrogen has been getting more airtime with new announcements seemingly coming every day. Examples include:

• Europe dramatically increasing hydrogen targets following the Russian invasion of Ukraine, with goals of producing 10M tonnes and importing another 10M tonnes by 2030.

• Japan shifting away from coal and towards hydrogen, with plans to establish a full-scale hydrogen supply chain by 2030 including 20% of coal power plants co-fired by ammonia and 30% of gas power plants co-fired by hydrogen.

• SSAB’s successful green hydrogen-powered steel plant in Luleå, Sweden, and subsequent plan to shut down all its blast furnaces by 2030.

• Billionaire Gautam Adani’s partnership with TotalEnergies to invest $50B in green hydrogen over the next decade.

• BP taking a stake in a $30B project to produce 1.6M tonnes of hydrogen or 9M tonnes of ammonia per year using solar and wind power in the Australian outback.

• Shell’s plan to build Europe’s largest renewable hydrogen plant.

• Advances in hydrogen for airplanes, including Rolls Royce and easyJet’s successful run of a hydrogen-powered aero engine and Airbus’s plans to partner with GE and CFM to put hydrogen-powered plane in service by 2035.

This groundswell of publicity should help create a virtuous cycle that leads to better appreciation for its potential and therefore more initiatives to use it in new applications.

In addition to the major categories listed above, APD has growth opportunities in its base business. For instance, APD is a major supplier of nitrogen to the electronics industry. Management claims they have as good or better technology in high-purity nitrogen as any player in the field, and that they are winning their fair share of new electronics business. For instance, in Q2 2022 they booked two new take-or-pay contracts worth $1.3B with major semiconductor companies. Also, APD’s LNG equipment business is well below its 2015 peak of $200M in EBITDA and could regain and surpass that level in coming years. APD claims to be the technology of choice for the emerging floating LNG market, and the world’s leading provider of patented LNG technology and equipment. A major part of their offering is LNG heat exchangers, which convert natural gas to liquid and are an integral part of all LNG projects (management claims around 85% of major LNG facilities use their technology). In addition, industrial gases in general should grow roughly in line with industrial production. As such, APD should produce something like 3-5% organic revenue growth even before the major growth projects are considered.

APD’s growth areas are all active today and do not depend on new technology development. In fact, many have been in use for years if not decades. Furthermore, these markets are large and have the potential to be truly massive. By way of example, APD’s $1.5B investment in the first phase of Jazan produces $0.80-$0.85 per share in EPS. The $0.9B investment in the second phase (closing in 2023, once they reach mechanical completion on the phase two assets) should produce an incremental $0.50-$0.55 per share in EPS for ten years, reducing to an incremental $0.30-$0.35 in years 11 through 15 due to mortgage-like financing accounting (the annual cash fee holds steady with a small escalator for labor). The economics could change after year 15 due to financing optionality, so management didn’t provide a target beyond year 15. This works out to about $750M of actual EBITDA to APD for 25 years (some of which will be needed to pay down project debt). Another perspective is NEOM. The NEOM project, which will cost billions to build, will produce enough hydrogen to power 20,000 city buses. There are around 3 million city buses in the world, and that’s just buses. From there we can think about trucks, trains, planes, ships, etc. and in heavy transportation alone the sheer size of the opportunity is hard to imagine.

We can also look at what some of the forecasters are saying. Goldman Sachs believes hydrogen generation could double to $250B by 2030 and quadruple from there to $1T by 2050. The IEA and the International Renewable Energy Agency think hydrogen could meet 12-13% of energy demand by 2050. The Hydrogen Council, an industry group, is even more bullish. It estimates that 22% of global energy could be from hydrogen by 2050, with the market for hydrogen and hydrogen technologies reaching $2.5T (up from $240B in 2030). The bulk of the growth is expected to come from green hydrogen, although blue’s growth potential is also substantial (chart from Nature):

Seeing this kind of growth from green hydrogen, however, will require massive investments in renewable electricity generation.

Recent Results

Although our thesis is long-term in nature, it is useful to look quickly at some more current results. APD has put up good numbers in recent quarters despite the difficult environment. The biggest test was how well the merchant business (liquid bulk and packaged) would be able to pass through higher energy and other commodity costs. While the speed of the inflation caught management a bit off guard (especially in Europe, where energy costs were up nearly 6x in Q4 2022 over Q2 2021), they were able to catch up within a quarter or two and ultimately recaptured all the costs and then some. This was a positive indication of the strength of the moat. Volumes have also generally been decent, with strength in the Americas offsetting Covid impacts in Asia and war impacts in Europe. Volumes have also benefited from new projects coming online (such as Jazan phase one). On the flip side, they have struggled with strong foreign currency headwinds (revenues and costs are denominated in local currency; FX was a 3% hit to 2022 EPS), higher labor costs (particularly driver shortages), supply chain disruptions, investment in new projects and a resumption of pre-Covid costs that were temporarily on hold. As such, margins have been somewhat pressured even after adjusting for the accounting impact of higher pass-through energy and commodity costs. Still, overall management has steered the company well and posted strong profits and returns on capital, with EPS up 15% in 2022 and pretax ROIC flat year-over-year at 17%. Their guidance for 2023 assumes 11% EPS growth, despite a 5% headwind from FX.

Risks

Some of the more meaningful risks include:

1. Ghasemi is 78 years old and has been in the CEO position since 2014. There is some risk around his transition out, as retirement can’t be too far away. The COO, Dr. Samir Serhan, seems to be the likely successor, though he is already 61. Dr. Serhan worked at Praxair and Linde prior to joining APD in 2016.

2. These are massive projects, often in developing countries, and there is execution risk around timing, function, and cost. For instance, the Lu’An project in China, one of the earliest ones APD executed as part of its new strategy, hit some road bumps during maintenance and went offline temporarily, causing some issues in 2020 and 2021. Some of these large projects also involve hydrogen market risk (primarily for green and blue hydrogen). Furthermore, APD’s main competitors, Linde and L’Air Liquide, have pursued the gasification business largely through licensing and tolling deals rather than through large-scale on-balance sheet investments. L’Air Liquide and Linde are both significantly larger than APD, following their mergers with Airgas (2016) and Praxair (2018), respectively. Either competitor could create weaker economics for these types of projects should they choose to compete more aggressively.

3. The growth of hydrogen will be in part influenced by tax and other government-led incentives and regulations. While these will differ from country to country, this creates regulatory risk. In addition, growth of hydrogen will be in part influenced by the economics and technology associated with developing more and more use cases for the fuel. This also introduces some risk to the thesis. Furthermore, new technologies might not require APD’s expertise and capital.

4. Around 18% of revenues come from refinery customers. Refineries face an uncertain future with the slow phasing out of gasoline and other fuels for use in passenger and other forms of transportation. While many refineries will likely find ways to adapt (such as shifting to petrochemical end markets) and the process will likely be slow, it remains a risk to APD over time.

5. APD is levered to industrial production and can therefore exhibit a certain amount of cyclicality. However, the contractual nature of a large portion of the revenue base helps mitigate this cyclicality.

Valuation

Before we get into the valuation, note that for accounting purposes we move the equity earnings contribution from the JVs above the line (meaning, it becomes a part of operating income). This is not a “pure” treatment as the equity income from JVs is equivalent to earnings (that is, it’s after interest and tax), and the revenue is unadjusted as is the balance sheet, but it’s a good enough proxy that keeps things reasonably simple.

At today’s price of $315, APD has a market cap of $70B and an enterprise value of $75B. It trades at 18x trailing EBITDA, 25x trailing EBITA, 30x trailing earnings and 24x trailing distributable cash flow. APD discloses maintenance capex, so we can calculate distributable cash flow (we define it as EBITDA less maintenance capex, interest, and normalized tax). We believe the earnings and cash flow multiples are the most useful. Today’s multiples are slightly above the 5-year historical averages, which we calculate at 28x earnings and 22x cash flow. Looking at forward multiples, APD trades at 28x consensus earnings, vs. a 5-year historical average forward multiple of 25x. From this perspective we can say that APD trades roughly in line with its historical multiples even though its growth prospects are arguably considerably brighter. Said differently, we don’t seem to be paying much for the tremendous optionality around hydrogen, gasification, and carbon capture.

Another angle to consider is comparable companies, L’Air Liquide and Linde. First to note that there are a few differences that stand out:

• The comps are significantly larger (revenue, profits, enterprise value), but APD earns higher returns on capital.

• The comps are headquartered overseas (France and the UK).

• The comps have more diversified businesses.

• APD has a much higher mix of on-site business, at around 2x the comps.

The much larger Linde trades at a higher multiple than L’Air Liquide, with a trailing P/E of 28x vs. 24x. APD is slightly richer in this sense than Linde, though it is also arguably a better business with better growth prospects. The EBITDA and EBIT multiples tell a similar story.

The last and arguably most interesting perspective we’ll consider is a five-year forward-looking model. This projection lines up with management’s 2027 pipeline and expectations of investing $36.5B over 10 years. We consider two key inputs for this exercise: growth in invested capital, and ROIC:

• Invested capital: since 2017, APD has grown invested capital at a 12% CAGR. The last three years have seen consistent growth around 13-14%, after a slow year in 2019 and a 15% year in 2018. We will assume that APD grows invested capital at a 13.5% CAGR over the next five years. This would result in average invested capital in year five of $32B. By comparison, if management hits its goal their invested capital will look more like $42B, so we are arguably being quite conservative. Said differently, our projection captures their committed backlog without assuming any additional capital is put to work above that.

• ROIC: since 2017, APD’s ROIC has ranged from 17.3% to 19.5%. We will assume 19.0% for our model, as the lower figures in the historical context are burdened by high amounts of unearning capital. While this may still be the case in 2027, we get a purer view of earnings power if we assume a more typical return profile on the capital base. This assumption results in $6B of EBITA in 2027 (19% ROIC x $32B capital).

Our math presumes that APD maintains a 60% dividend payout ratio and invests all retained earnings in equity capital ($7B cumulatively). The remainder of the capital needs are funded with debt ($8B cumulatively). This works out to under 2x net debt to EBITDA in 2027, well within management’s target leverage range.

The $6B of EBITA drops down to $4.5B of earnings after deducting interest and taxes. If we capitalize that at 30x, we’d have a stock price in 2027 of a bit over $600. Adding in annual dividends produces an IRR of over 16% from today’s purchase price. This chart gives some sensitivities around the key assumptions and shows an attractive (10%+) IRR in most reasonable scenarios:

One can argue that the 30x P/E, while consistent with the current and historical multiple, is not sufficiently conservative. Here is the math assuming the multiple contracts to 23x:

We would argue the multiple is more likely to go up rather than down. First, as APD continues to drive growth through large projects, its mix of on-site business will increase commensurately. Management believes they could be 70% on-site in about ten years. This should deserve a higher multiple. Second, over time the investor labeling of APD could move from “industrial gas company” to “green energy company.” This could have significant implications for the stock multiple.

In summary, we find the valuation attractive, providing reasonable downside protection and significant positive skewness.

Disclosures

The information contained herein has been derived from public information believed to be reliable but the information is not guaranteed as to accuracy and does not purport to be a complete analysis of any security, company or industry involved. All data and analysis are unaudited and should not be used as the basis for any investment decisions. Neither the advisor, nor any of its officers, directors, partners, contributors, employees or consultants, accept any liability whatsoever for any direct or consequential loss arising from any use of information in this analysis. The user of the information assumes the entire risk of any use it may make or permit to be made of the information.

Neither the advisor nor any of its employees holds a position with the issuer such as employment, directorship, or consultancy.

The adviser, through accounts that it advises, may hold an investment in the issuer's securities.

Catalyst

Continued press around hydrogen, gasification and carbon capture