Praxair (PX): Strong Moat, 20+ Years of Dividend Growth, But Macro Headwinds Persist

Praxair (PX) has increased its dividend for 22 consecutive years and offers one of the highest quality cash flow streams an investor can find. With the stock down over 20% in 2015 and offering a 2.8% yield, it might be time for investors to consider taking a nibble in this blue chip dividend growth stock.

 

Business Overview

PX was founded in 1907 and is one of the largest producers of industrial gases (e.g. oxygen, hydrogen, argon, helium, nitrogen, carbon dioxide) in the world. Customers use PX’s gases in their operations and manufacturing processes and receive the gases via pipeline, truckload, or in packaged containers.

 

PX operates a very capital intensive business that is well diversified by gas distribution method, geography, and end market (healthcare, petroleum refining, computer-chip manufacturing, beverage carbonation, fiber-optics, steel making, aerospace, chemicals and water treatment).

 

The majority of PX’s business is conducted through long-term contracts which provide stability in cash flow and the ability to pass through changes in energy and feedstock costs to customers.

 

From a gas distribution standpoint, on-site plants account for 29% of sales (supplied directly via pipeline), merchant is 34% (tanker trucks deliver to customer storage containers), packaged gas is 29% (supplied in high pressure metal containers), and other delivery methods are 8% of total revenue.

 

The company is very diversified by end market: manufacturing 24% of sales, metals 17%, energy 13%, chemicals 10%, healthcare 8%, electronics 8%, food & beverage 8%, aerospace 3%, other 9%.

 

By geography, PX generates 54% of its sales in North America, 12% in Europe, 14% in Asia, 14% in South America, and 6% in other countries.

 

Business Analysis

Despite PX’s sensitivity to economic activity, we believe the company has a strong economic moat for several reasons.

 

The industrial gas business is extremely capital intensive. Large manufacturing plants take around three years to construct, costly pipelines and a large fleet of delivery equipment must be assembled, and everything needs to comply with technical regulations. However, funding these needs is only the beginning of the challenges faced by new entrants.

 

The price customers pay for industrial gas is not high, and gas typically accounts for just a small portion of their overall manufacturing costs. However, the cost to transport the gas to the customer is often substantial – gases often need to be stored at a certain pressure and temperature, significantly limiting how far they can be transported at a competitive price. PX has stated that its distribution radius is no more than a couple hundred miles from its manufacturing plant.

 

Trying to battle an incumbent on price alone is a losing battle when they have greater network density and lower costs of production than you. If they felt threatened, they could temporarily reduce their prices to squeeze out higher cost producers that are threatening a particular region.

 

Furthermore, PX has strong customer relationships and many long-term, take-or-pay contracts that make its markets all the more difficult to break into. A meaningful amount of its gas is also shipped directly to customers via pipeline, creating high switching costs. Each local market is typically dominated by the company with the densest distribution network because they operate more efficiently.

 

For these reasons, many of PX’s customers are highly dependent on it for their industrial gas needs, which are generally mission-critical to their operations and manufacturing processes. Since there are few viable competitive alternatives and the cost of industrial gas is such a small proportion of customers’’ total costs, PX typically enjoys strong pricing power.

 

While PX is facing several meaningful macro headwinds at the moment, the company was able to improve its operating margin to an all-time high last quarter because of higher pricing and strong cost controls. The company also announced it would raise prices by up to 20% for North American customers earlier this year. Few companies have such pricing power.

 

The industrial gas industry is also very slow-changing. The production methods used to create industrial gases haven’t changed much over time, and customers’ applications of gases have gradually expanded. There really aren’t any meaningful substitutes for these products, and the localized nature of each market ensures a generally healthy competitive environment.

 

While market players do consumer significant amounts of natural gas and electricity in their manufacturing process, they also have a unique raw material cost benefit. Many industrial gases are produced by air separation – literally using air from the atmosphere and cleaning, purifying, processing, and separating it into useful gases. It’s hard to find a cheaper input cost than air!

 

Altogether, PX’s substantial economies of scale, dense distribution networks, long-term supply contracts, and strong pricing power result in good returns on invested capital, predictable cash flows, and consistent long-term growth opportunities.

 

Of the major gas players (ARG, APD, Air Liquide, Linde), PX has the highest operating margin, return on capital, and cash flow margin. PX’s financial leadership seems to suggest that the company has been one of the most disciplined capital allocators and/or dominates some of the most attractive regions. This durable business isn’t going away anytime soon.

 

Key Risks

While PX’s business model has many strengths and defensive qualities, it is sensitive to economic activity. When GDP growth slows and commodity prices fall, fewer metals need to be manufactured, demand for chemicals drops, gas and oil refining activity slows, and more.

 

PX’s stock price is down over 20% in 2015 for many of these reasons. Upstream energy markets are weakening (13% of sales), Brazil (18% in 2011, closer to 9% today) is in a recession, China (6%) continues slowing down, and the strong dollar is hurting sales and earnings growth (over 50% of sales are outside the U.S.).

 

As long-term dividend growth investors, we would normally be licking our chops after seeing these transitory headwinds, which should ultimately reverse and lead to brighter times for PX.

 

However, we fear that some of these headwinds could persist for a very long time and potentially cause larger risks in the next year or two. While we wouldn’t expect any sort of dramatic fallout like the one that rippled through the master limited partnerships sector, some of the defensive characteristics of PX’s business model could be increasingly challenged.

 

For example, if commodity prices remain low and continue pressuring demand for steel, some customers could be unprofitable. If their production volumes drop below the minimum level in their take-or-pay contracts with PX and they don’t have the cash flow to pay, what happens?

 

After years of rapid buildouts, many of these manufacturing, energy, and chemical markets could be oversupplied for several years in countries such as China and Brazil. How safe is the cash flow from some of these customers as they grapple with capacity rationalization? We also wonder if PX’s backlog could start to contract if things get really bad, creating more fears around the stock, or if it will experience delays when it starts to ramp up some of its major new projects in the next 1-2 years (these are from major investments made during 2011 through 2014).

 

Furthermore, fewer new growth opportunities in developing countries could lead to higher competition and lower returns for the remaining pool of projects that do exist. If the battle for market share intensifies between incumbents, future returns on capital could contract or PX will see less growth. The industry has historically acted rationally, but desperate times could call for desperate measures.

 

We would also prefer if PX had a healthier balance sheet to provide greater flexibility in case some of these risks materialize. The company has an “A” credit rating, but it only has $136 million in cash on hand compared to $9.5 billion in debt.

 

Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. PX’s long-term dividend and fundamental data charts can all be seen by clicking here.

 

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

PX recorded a dividend Safety Score of 44, suggesting that its dividend is about as safe as the average stock in the market. Despite the company’s high quality level, its debt situation ($136 million in cash compared to $9.5 billion in debt) and the current macro headwinds add to its risk profile. However, assuming PX’s cash flow generation remains steady, there shouldn’t be anything to worry about.

 

Using 2016 earnings estimates, PX’s earnings payout ratio is a healthy 47%. Given the stability of PX’s free cash flow, the company has plenty of room to continue paying and growing its dividend.

 

Looking below, we can see that PX’s earnings payout ratio has remained between 30% and 50% over the past 10 years. Its free cash flow payout ratio has been more volatile because the company’s growth investments are costly with cash flow benefits spread over many years but the price of the project paid over just several years. Even with continued macro pressures, PX’s dividend looks safe.

 

 

Despite PX’s exposure to numerous industrial markets, the company’s performance during the financial crisis was very good. Sales fell by 17% in 2009, but the company expanded its operating margins each year and actually grew earnings. When sales growth slows, PX actually has more free cash flow to work with because it doesn’t need to invest as much in growth capex.

 

 

Courtesy of the company’s annual report, we can see that PX has generated higher operating margins than the industry average while demonstrating remarkable stability during each of the five recessions over the last 25+ years.

 

 

Not surprisingly, PX has generated free cash flow in each of the last 10 years. The long-term, take-or-pay contracts and strong pricing power of the business make it a big cash generator despite the capital intensity. Management has stated that roughly 75% of the company’s capex today is related to growth projects, not maintenance work. PX will really be a free cash flow machine when its long-term reinvestment rate slows, but we don’t expect that to happen anytime soon. The company’s capex was elevated from 2011-2014, and it should start seeing the benefits from these growth investments in late 2016 and beyond.

 

 

Turning to the balance sheet, PX maintains a lot of debt relative to its cash on hand and earnings power. We would be concerned by this is the company wasn’t such a dependable free cash flow generator in almost every macro environment.

 

Furthermore, we believe free cash flow generation will improve over the next several years as growth capex moderates and new projects start generating revenue. It’s also worth noting that the rating agencies have assigned PX an “A” credit rating, and the company has noted it will do anything to maintain its current status with the agencies.

 

 

Altogether, PX’s dividend looks pretty safe. The company’s payout ratio is reasonable, it generates cash flow in practically any environment, and its strong credit rating should provide it with access to capital markets in the event that any negative surprises surface.

 

Dividend Growth Score

Our 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.

 

PX’s dividend growth potential ranks below average with a dividend Growth Score of 24. Macro challenges are weighing on sales and earnings growth, and the company’s balance sheet has less flexibility than many other companies.

 

With that said, PX has increased its dividend for 22 consecutive years – not long enough to be on the dividend aristocrats list, but a very solid track record nonetheless. The company raised its dividend by 10% earlier this year and shouldn’t have a problem with continued increases given its steady free cash flow generation.

 

As seen below, dividend growth has decelerated over the last 10 years. Going forward, PX plans to grow the dividend at least in line with earnings growth every year.

 

 

Going forward, we believe PX will continue increasing its dividend at a high-single digit rate, although 2016 could come in a bit lower as the company digests an acquisition and continues battling macro headwinds.

 

Valuation

PX trades at about 17x forward earnings estimates and has a dividend yield of 2.8% – not enough to live on in retirement, but a decent starting yield given PX’s dividend growth. With long-term earnings growth likely in the 7-11% range (management believes earnings growth will return to a double-digit rate when cyclical macro headwinds turn) the stock appears to offer total return potential of 10-14% per year – not bad at all for an extremely high quality business like PX’s.

 

However, with no end in sight to PX’s macro headwinds and potential for things to get worse before they get better, it’s hard to make the case to go “all in” today. With that said, we do expect these challenges to eventually reverse and can see how a case could be made to start averaging into the stock today. Saving some dry powder in the event that macro conditions further deteriorate in 2016 isn’t a bad idea.

 

Conclusion

PX is an excellent business trading at a reasonable price. However, the macro headwinds impacting its business seem likely to persist for at least the next 6-12 months. While the likelihood is probably low, these challenges could also morph into an even greater problem if certain customers in commodity-sensitive sectors such as metals (17% of sales) and energy (13%) are no longer able to honor their take-or-pay contracts. Brazil (~10% of sales) and China (6%) could also get worse before they get better.

 

PX will get through whatever macro challenges are thrown at it, just like it has every other time over the last 100+ years. The company’s business model remains very strong during recessionary times, and the dividend appears to be reasonably safe (although we wouldn’t mind seeing the company put a little more cash on the balance sheet).

 

While no one can predict the future, PX seems like a reasonable bet for dividend growth investors willing to hold on for at least five years. However, the investment’s timeliness seems low given the persistence of today’s macro headwinds. We would be more interested if the stock weakened even further during 2016.

 

We don’t own the stock in our Top 20 Dividend Stocks portfolio but will keep it on our watch list.