A closer look at Air Products and Chemicals

Today, I'm digging deeper into industrial gas company Air Products and Chemicals (APD) to see if the stock looks compelling in the wake of activist-investor involvement...

Last Monday, I took a first look at the company, which has attracted the attention of two well-respected – yet very different – activist investors: D.E. Shaw and Mantle Ridge.

The latter is run by Paul Hilal, one of my oldest, closest friends – dating back 37 years when I met him at Harvard through his roommate, Pershing Square's Bill Ackman.

Paul worked for Bill at Pershing Square for many years and led Pershing Square's investment in APD, which was disclosed in July 2013.

They were instrumental in bringing in the current CEO, Seifi Ghasemi, in mid-2014. He oversaw strong performance of the stock through late 2020, though it has traded sideways since then. Take a look...

To see why shareholders are dissatisfied, look no further than this stock chart, which shows that APD had badly trailed its peers Linde (LIN) and France-based L'Air Liquide (which trades on the Paris stock exchange under the ticker AI.PA, with an over-the-counter listing here in the U.S. under the ticker AIQUY) as well as the S&P 500 Index over the past four years:

And to understand why APD has underperformed, look no further than this chart from last week's e-mail, in which I showed APD's cash flow from operations, capital expenditures ("capex"), and free cash flow ("FCF"):

As I wrote last week:

... capex has exploded, soaring from a low of $908 million in 2016 to a staggering $6.2 billion in the last year – driven by investments in green energy. This has resulted in increasingly negative FCF over the past two years.

APD's green-energy investments have yet to pay off, and I have little doubt that Mantle Ridge will be asking some tough questions in this area.

I should have also added "and D.E. Shaw"... because, sure enough, last Thursday the hedge fund released a strongly worded letter accompanied by a 50-slide presentation that critiqued Ghasemi and the board and called for the following seven things:

1. Accelerate efforts to de-risk existing large project commitments by signing offtake agreements at reasonable return hurdles;
2. Publicly commit to tying future capital investment to offtake agreements, consistent with well-established practice in the industrial gas sector;
3. Establish and publicly announce a new capital allocation framework whereby Air Products' CapEx levels will not exceed the mid-teens as a percentage of revenue beyond fiscal year 2026;
4. Communicate a clear, credible, and transparent CEO succession plan;
5. Refresh the Board with highly qualified, independent directors with relevant experience leading capital-intensive businesses and managing succession processes;
6. Restructure executive compensation to improve alignment with strategy and performance; and
7. Form one or more ad hoc Board committees to focus on and oversee these critical initiatives on behalf of shareholders.

D.E. Shaw also disclosed to CNBC that it "plans to nominate three directors to the company's board."

The first three items on D.E. Shaw's list relate to capital allocation. To understand why investors think APD has gone awry in this area, it's important to understand how great this business is...

Industrial gases are critical to customers' operations but are only a tiny fraction of their cost structure, so they care about purity and reliability above all else. So even if a new competitor came in and offered gases for free, many customers would likely decline the offer. It's a simple, predictable business that generates a ton of free cash – and faces few of the risks of most other businesses:

• It's not cyclical because most revenues come from 15-year take-or-pay contracts (called "offtake agreements") (notice in the chart above that APD's operating cash flow increased in 2020 in spite of the pandemic)
• Inflation adjustments are built into contracts
• Industrial gas projects are fairly cookie-cutter and don't require novel, untested technologies, so delays and/or cost overruns are rare

As a result of such stable and mouth-watering economic characteristics, investors rightly award high earnings multiples to the stocks of the three companies that dominate this industry.

As you can see in this chart, all of their stocks have generally traded between 20 times and 35 times forward price-to-earnings (P/E) estimates over the past five years:

In particular, note that APD often traded at the high end of the group, until early 2023 when it declined from 28 times down to 24 times... and then later that year to around 20 times... and as low as 17 times earlier this year. Today, the multiple is nearly 24 times.

The main reason APD's multiple has contracted so much (while its peers' multiples haven't) is that, as I noted earlier, the company has massively ramped up capex to fund risky new green-energy projects, as you can see in this slide from the D.E. Shaw presentation:

This has led to declining FCF and returns on capital and, in the absence of the usual offtake agreements, a substantially greater risk profile – as this next slide from the D.E. Shaw presentation highlights:

This is not what investors in this sector signed up for... and they have been vocal in their displeasure, but Ghasemi has dug in his heels and defended this misguided "deworsification" strategy again and again. Take a look at this slide from the D.E. Shaw presentation:

In frustration, investors have abandoned the stock.

So the first and most important step of the activists' playbook is to persuade APD to reverse its risky strategy by scaling back future green-energy investments and signing offtake agreements for existing ones, thereby returning the business to its roots.

Can the CEO who took the company in the wrong direction reverse course?

I doubt it...

By all accounts, Ghasemi is a brilliant, passionate, driven CEO. He was exactly the right person to improve the operations of the business from when he took over in 2014 through 2020, as net profit margins more than doubled from 9.5% to 21.3%.

But at that point, creating future value depended more on capital allocation – and in this area, Ghasemi has been a good case study in a phenomenon that Warren Buffett warned about in his 1987 annual letter:

The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.

CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers. Charlie [Munger] and I have frequently observed the consequences of such "help." On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.

In the end, plenty of unintelligent capital allocation takes place in corporate America.

Ghasemi is 80 years old. And APD is an operationally intensive business with 23,000 employees across the globe.

So it's clear that when D.E. Shaw writes, "communicate a clear, credible, and transparent CEO succession plan," what the firm is really saying is that Ghasemi needs to step down gracefully... and quickly.

If the activists succeed in persuading APD to reform its capital-allocation strategy and replace Ghasemi, I think it's likely that the forward earnings multiple on the stock would revert to near 30 times (Linde today is at around 29 times), which, combined with continued earnings growth, would take the stock over the next year from today's recent level around $317 per share to the $400-per-share range.

So the final question is whether the activists will succeed...

I think the odds of success were, say, 60% based on D.E. Shaw's track record, the underperformance of the stock, and the merits of their case.

But with Mantle Ridge involved, I think the odds of success are now 90%.

There are two reasons for this...

The first is that Mantle Ridge, unlike nearly all other activists, takes a collegial, respectful, and discreet approach and is a long-term owner.

For example, Paul Hilal has been vice chairman of railway company CSX (CSX) since he first invested nearly eight years ago (for more on him, see this October 2019 article in Activist Insight: The Perfectionist). This approach results in companies being more willing to invite them on to their boards and make changes. So Mantle Ridge is the perfect complement to D.E. Shaw's more aggressive approach.

Second, Paul led Pershing Square's investment in APD in July 2013, which led two months later to the announcement of the retirement of then-CEO John McGlade and three new board members.

Then in 2014, APD named Ghasemi its chairman and CEO. So Paul doesn't just have a deep relationship with Ghasemi, but he is basically running the exact same playbook as a decade ago.

We know how well that ended last time, and I think it's a good bet that history will repeat itself.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.