A 'first look' at Air Products and Chemicals amid a big activist-investor stake

Today and tomorrow, I'd like to take a "first look" at two new opportunities in the area I call "piggybacking on activism"...

This refers to buying stocks of companies in which an activist investor is pushing for change. If I think their plan will unlock value and they're likely to be successful, I jump on board and, while they do the hard work, profit alongside them for free.

Today I'll look at industrial gas company Air Products and Chemicals (APD) and tomorrow I'll look at drug giant Pfizer (PFE).

Shares of APD popped as much as 9% this morning in the wake of this Wall Street Journal article from Friday: Activist Mantle Ridge Has Over $1 Billion Stake in Air Products. Excerpt:

Activist investor Mantle Ridge has built a more than $1 billion stake in Air Products and plans to push for improvements at the industrial gas manufacturer, according to people familiar with the matter.

Mantle Ridge has been building its position in Air Products since March, the people said.

Air Products, based in Allentown, Pa., had a market value of around $63 billion as of Friday. Its shares are up about 4% so far this year, compared with a 20% rise in the S&P 500.

Mantle Ridge, run by Paul Hilal, plans to push Air Products executives on succession planning for Chief Executive Seifi Ghasemi as well as on improvements to the company's strategy and capital allocation, the people said. The firm believes Air Products is trading at a discount to its peers, they added.

The news really caught my attention because Paul is 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, disclosed in July 2013, in none other than Air Products.

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

As you can see, APD's stock tumbled earlier this year, which is when Paul began scooping up shares.

Paul is best known for leading Pershing Square's successful activist campaign in railway company Canadian Pacific (CP). After taking control of the company, Paul and Bill replaced the CEO with the man famous for "precision railroading," E. Hunter Harrison, who led a turnaround. Margins and profits soared, the stock followed, and Pershing Square netted a $2 billion profit by the time it exited in 2016.

Paul left Pershing Square to start Mantle Ridge that year and his first investment was in another railway company, CSX (CSX). Taking a page from his earlier playbook, Paul lured Harrison away from CP and he led another successful and profitable turnaround.

Here's a 10-year chart of CSX with a circle around the stock's jump on January 18, 2017 – the day Mantle Ridge disclosed its position in the company:

Unlike a typical hedge fund, Mantle Ridge only invests in one company every one to two years. Other investments since CSX include food-service company Aramark (ARMK) and retailer Dollar Tree (DLTR).

So, having established Paul's great track record as an activist investor, let's take a look at APD today. As always, I start with two decades of financials...

We can see that, after a drop in 2015 due to divesting some non-core businesses, APD's revenue and operating income have grown strongly since then:

But the cash-flow statement tells a more troubling story. Take a look at this chart of APD's cash flow from operations, capital expenditures ("capex"), and free cash flow ("FCF"):

The company's operating cash flow hasn't grown nearly as much as profits – it has barely risen over the past five years. And worse yet, 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.

To my surprise, APD hasn't used its FCF to buy back any stock in the past decade – instead choosing to pay a solid dividend (the current yield is about 2.5%), which has risen roughly in line with the stock price. Take a look:

As you can see in this next chart, the combination of rising dividend payouts and accelerating negative FCF has led to net debt more than doubling in less than two years from $5.1 billion to $12.3 billion:

Lastly, let's take a quick look at APD's valuation...

Including the jump in the shares this morning, its enterprise value of $82.6 billion is equal to 6.8 times trailing revenue and 16.7 times earnings before interest, taxes, depreciation, and amortization ("EBITDA"). And with the stock recently trading around $305 per share, it's trading at 24.7 times earnings estimates for this year (ending September 30) of $12.35 per share.

I wouldn't call this expensive for a high-quality business like APD... but it's not cheap, either.

In summary, based on what I know about Paul and the mixed picture regarding APD's financials, I'm intrigued enough to take a deeper dive... so stay tuned for more!

Best regards,

Whitney

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