Air Products & Chemicals (APD): A Dividend Aristocrat With Improving Payout Growth Prospects

Air Products & Chemicals (APD), is one of the few (51 S&P 500 companies) to make it into the dividend aristocrat club, meaning that it’s been raising its dividend for at least 25 consecutive years.

 

In fact, since 1983 Air Products has been growing its dividend at an annual rate of 9.6%, which has not only resulted in exponentially growing income for shareholders, but also decades of market-beating total returns (10.5% annual total return vs 8.7% for the S&P 500 over the last 22 years).

 

However, the key to such consistent success is being able to evolve with changing market and industrial conditions, which in recent years have been rather challenging for APD and resulted in much slower payout growth than in the past.

 

Let’s take a closer look at what management is doing to not only keep the company’s impressive payout growth streak alive but also turnaround the overall business model to re-accelerate dividend growth.

 

Business Overview

Founded in 1940 in Allentown, Pennsylvania, Air Products & Chemicals is one of the world’s largest provider of atmospheric gases, process and specialty gases, electronics and performance materials, equipment, and services to a host of large global clients in over 30 industries in more than 50 countries.

 

Its 17,000 employees operate over 750 manufacturing facilities, as well as 1,800 miles of industrial gas pipelines. Air Products is the world’s largest supplier of hydrogen and helium with approximately 40% market share in those two critical gases.

 

In other words, APD is one of those classic, boring industrial giants providing things like liquid oxygen, nitrogen, argon, hydrogen, helium, carbon dioxide, carbon monoxide, syngas, and rare gases to companies that use them in the manufacturing of metals, glass, chemical processing, electronics, energy production and refining, food processing, metallurgical, medical, and general manufacturing.

 

 

The company is highly diversified geographically, with a strong presence in not just North America and Europe, but also fast-growing emerging markets in Asia and Latin America.

 

Source: 2016 Annual Report

 

Note that in 2016 APD decided to discontinue its materials technologies division by selling off certain assets to Evonik Industries AG for $3.8 billion and spinning off the rest of the unit into shares of Versum Materials to shareholders in October 2016. These actions allowed Air Products to focus completely on its industrial gas businesses.

 

Business Analysis

The key to becoming a dividend aristocrat is to have a highly predictable, stable, growing source of revenue, earnings, and cash flow. Preferably one protected by a wide moat, meaning competitive advantages that allow a company to maintain or grow profitability over time.

 

When it comes to industrial gases, while the products themselves are entirely commoditized, the manufacturing and distribution processes of them is actually highly complex. For example, a new gas facility can cost $2 billion to $3 billion and take several years to construct, assuming all technical regulations are complied with.

 

In addition, while the gas itself is usually low cost (air is a very cheap raw material), transporting and storing it is far more complex and expensive (e.g. liquid oxygen put in a tanker will evaporate after 200 miles). That’s because it requires advanced infrastructure such as cryogenic gas storage equipment, large pipeline networks, and vast fleets of specialized tanker trucks.

 

These substantial costs mean that smaller rivals can’t compete well on price because customers ultimately care more about reliable delivery of gases from sizable distribution networks that only large players can provide.

 

The high transportation costs also make industrial gas a local business, with competition typically limited to a radius no greater than a couple hundred miles. When combined with Air Products’ long-term contracts and relationships with many customers, new entrants have a hard time taking market share.

 

Since gas typically accounts for just a small portion of a customer’s total manufacturing costs and is a non-discretionary expense, APD is able to enjoy some pricing power as well.

 

While the industrial gas industry is characterized by a slow pace of technological change, resulting in less risk of disruption, it is highly cyclical as you can see below.

 

 

So in order to better compete against rivals such as Praxair (PX), management announced the largest restructuring in the company’s history in 2014 with five specific goals:

• Be the safest industrial company in the world
• Become the most profitable company in the industry
• Divest non-core (slow growth, low margin) businesses
• Achieve the strongest balance sheet in the industry
• Achieve long-term 10% EPS and FCF per share growth

 

 

Over the past three years APD has largely delivered on these goals, including:

• 83% improvement in lost time employee injury rate
• A 9.0% increase in EBITDA margin (36%) to an industry leading 34%
• Selling off the performance materials business, spinning off Versum Materials, and shutting down the energy from waste unit
• A rock solid balance sheet with $5 billion in available liquidity (to grow the business)
• Adjusted EPS growth (excluding restructuring costs) of 10%, 16%, 10%, and 10-11% in 2014, 2015, 2016, and 2017 guidance, respectively

 

Thanks to the company’s five-pronged turnaround strategy APD has seen a strong improvement its bottom line, which has resulted in very strong free cash flow (FCF) per share growth, which is ultimately what secures and grows the dividend.

 

In fact, since the start of the turnaround plan, APD’s FCF per share has grown from 38 cents to $7.46.

 

And thanks to management’s impressive ability to cut annual costs by $300 million over the past three years, with a further $300 million in savings targeted over by the end of 2019, APD’s profitability and returns on shareholder capital are the highest in their industry (at least for now).

 

 

This is partially due to the company adopting a highly disciplined investment strategy in which any capital investments over $3 million must be reviewed by the CFO and CEO, and only go forward if the company believes it can achieve a long-term 10+% return on investment. This includes building the sole hydrogen pipeline supplying Canada’s massive oil sands projects.

 

 

With APD continuing to win major projects around the world (current project backlog of $1.9 billion), specifically new gas manufacturing facilities that are underpinned by long-term contracts of 10-20 year durations with customers, shareholders can likely expect further growth in sales, earnings, FCF, and the dividend in the years ahead.

 

Key Risks

There are three key risks to consider with APD before investing.

 

First, as with all industrial companies, APD’s sales, earnings, and cash flow are cyclical (especially thanks to its heavy exposure to the energy industry), and its ultimate growth is limited by global GDP growth (historically the industrial gas industry grows at 1.2 to 1.4 times the rate of the global economy).

 

The good news is that through winning market share from smaller rivals as well as industry consolidation (APD and its top three rivals control 85% of the market), Air Products has managed to generate relatively steady growth in both its top and bottom lines.

 

That being said, continued consolidation may end up harming APD’s market share and its ability to generate strong economies of scale.

 

That’s because the 2016 Airgas-Airliquide merger, as well as the proposed $73 billion merger of Praxair and Linde, would leave Air Products as the smallest of the global industrial gas giants (and potentially minimizing its pricing power in the future).

 

Of course Air Products could try to acquire other rivals to keep up its market share; however, its M&A track record isn’t that great.

 

For example, over 10 years ago it tried to acquire BOC (a major rival) by partnering with Air Liquide. However, that deal fell through and Linde ended up with the prize.

 

Then in 2011 APD tried to acquire Airgas but failed, with Air Liquide ultimately buying that company.

 

In 2012 APD did manage to take over Chilean gas giant Indura; however by 2014 it was forced to write down most of that purchase at a loss due to poor execution and company integration.

 

Another big factor in Air Products’ historical success has been its strong position in Asia, especially China and now India, two of the world’s largest and fastest-growing economies.

 

However, we can’t forget that operating in these major markets is no easy task, especially given large cultural differences between the U.S., China, and India, especially when it comes to gaining regulatory approval to construct new facilities and win contracts with large, state-owned firms.

 

In other words, Air Products faces not only potentially shifting regulatory risks in the U.S. and Europe, but also in its most important growth markets.

 

And of course, while China and India are fast-growing economies with huge potential needs for industrial gases, their economies are also prone to occasional slowdowns, and China’s massive debt burden (304% of GDP as of May 2017) also has many economists concerned that a future recession in that country could have massive global economic repercussions.

 

Multi-national industrial giants such as APD could be particularly hard hit as many of their growth projects in China could be cancelled, and in a worst case scenario, some of their Chinese customers could default on payments.

 

Finally, as with with all trans-national firms, APD has a large and growing currency risk, as the majority of its sales, earnings, and cash flow are derived from overseas.

 

This risk will only grow over time as the company continues expanding and diversifying its operations overseas and could result in short to medium-term misses of management’s long-term EPS and FCF per share growth goals, especially if it isn’t able to grow its operating margins by 3% as currently planned.

 

Air Products’ Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

APD has a Dividend Safety Score of 78, indicating a highly secure and dependable payout, which is exactly what you’d expect from a company with 34 straight years of dividend growth under its belt.

 

 

There are two key factors to this kind of dividend safety and consistent growth.

 

The first is management’s disciplined approach to dividend growth, specifically to only increase the payout at a rate that maintains a safe EPS and FCF payout ratio.

 

Note that because of numerous restructuring charges in 2016, the FCF payout ratio was a far better dividend safety metric to look at last year. And as you can see, it’s been declining in recent years thanks to slower dividend growth that’s in line with management’s goal of creating the industry’s strongest balance sheet.

 

 

 

That balance sheet is the second protective factor because it allows management to invest in the future growth of the company without having to risk diverting free cash flow from the highly secure and steadily growing dividend.

 

Specifically, note that APD currently has enough cash on the balance sheet to cover the dividend for the next four and a half years.

 

 

In addition, the low net debt position and strong current ratio (short-term assets/short-term liabilities) means that APD’s financial position is especially strong, most notably when we compare the company’s metrics to those of its peers.

 

 

That’s because this is a highly capital intensive industry, which means that a high leverage ratio (Debt/EBITDA) is to be expected.

 

However, as you can see above, APD’s debt burden is much lower than the industry average, with a debt/capital ratio that’s less than half of its peers, and a very high interest coverage ratio that helps explain why APD enjoys such a strong investment-grade credit rating.

 

That allows it to borrow very cheaply, with an average interest rate on its debt of just 3.22% (vs 10-year Treasury yield near 2.2%), providing a strong competitive advantage in a rising rate environment.

 

Air Products’ Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

APD has a Dividend Growth Score of 38, indicating that shareholders should expect only moderate payout growth, perhaps somewhat below that of the broader S&P 500, in the coming years.

 

However, keep in mind that this is mostly due to the company’s recent slowdown in dividend growth, which management did on purpose so it could focus on bolstering the balance sheet.

 

 

Perhaps a better way to think of the company’s long-term dividend growth potential is by looking at management’s long-term EPS and FCF per share growth guidance, which is 10% or so (in constant currency terms).

 

That target seems reasonable given APD’s likely long-term sales growth of about 6%, which can be improved to 9% through planned margin expansion and 1% annual dividend buybacks.

 

Of course, because this is a highly cyclical industry, management could choose to pursue a slightly slower dividend growth rate than this, perhaps in the high single-digit range.

 

Valuation

Over the past year, APD’s share price has underperformed the S&P 500 by nearly 20%. As a result, APD’s valuation is starting to look interesting.

 

At first glance you may not think so, given that APD’s forward P/E ratio of 21.3 is higher than the S&P 500’s 17.4, the industry median of 19.6, and the company’s own historical norm of 19.3. However, when we consider the dividend yield, things look a lot different.

 

Specifically, APD’s 2.6% yield is not just significantly higher than the S&P 500’s 1.9% and the industry median of 1.8%, but it’s also greater than the 2.1% average yield APD has had over the past 22 years.

 

In fact, since 1995 APD’s yield has only been higher than it is today 15% of the time, specifically during the financial crisis and during 2012’s concerns over a potential debt crisis in Europe.

 

From a dividend yield perspective, today could be a reasonable time to consider APD, especially since investors have potential to achieve long-term annual total returns of 11.6% to 12.6% (2.6% yield + 9% to 10% annual earnings growth) in the coming years.

 

That double-digit total return potential is among the highest offered by any dividend aristocrat today.

 

Conclusion

Air Products & Chemicals is a classic boring, industrial blue chip, but one that has proven itself more than capable of maintaining and growing its market share over time in this vitally important industry.

 

With management’s turnaround efforts going well, dividend growth investors can likely expect much faster payout growth than in recent years, sufficient to likely generate healthy total returns for this dividend aristocrat.

 

Meanwhile, with APD’s yield currently at some of its highest levels in decades, today could be a reasonable time to give this reliable dividend grower closer consideration for a diversified income growth portfolio.

 

Investors looking for better yields can consider some of the best high dividend stocks here.