Petmal
Air Products and Chemicals (NYSE:APD) has become a pillar for the future of industrial gasification, with CEO Seifi Ghasemi highlighting sustainability at the core of growth initiatives. As new, long-term tailwinds materialize in the coming years and boost the company’s already strong foundation, management is uniquely positioned to outperform.
Encouraging, Not Disappointing Earnings
Figure 1: Financial Results (Air Products and Chemical Q1 2023 Presentation)
Figure 2: European Results (Air Products and Chemicals Q1 2023 10-Q)
Figure 3: European Power Costs (Air Products and Chemical Q1 2023 Presentation)
Figure 4: Asia Results (Air Products and Chemicals Q1 2023 10-Q)
Figure 5: Americas Results (Air Products and Chemicals Q1 2023 10-Q)
Figure 6: Historical Earnings CAGR (Air Products and Chemicals Q1 2023 Presentation)
Despite Non-GAAP earnings of $2.64 missing the street estimate of $2.58 and revenue of $3.17B missing the mark of $3.27B, the numbers tell a different story when digging deeper.
Fig. 1 shows us that a 7% increase in overall pricing, a 3% increase in energy pass-through costs, and a 2% increase in volumes all helped quarterly revenue rise 6% y/y.
At a regional glance, Europe and Asia had the most question marks coming into the Q1 print but passed their concerns with flying colors. Both regions, which represented 49% of sales in 2022, can become key contributors to drive earnings growth beyond the steady-performing Americas.
In Fig. 2, Europe had a 6% increase in revenues y/y due to 14% higher pricing and 9% higher energy pass-through costs. This allowed the company to achieve 18.4% operating margins, 510 basis points higher y/y, with operating income also rising an impressive 47%. These numbers were the largest increase from any region.
Investors can expect growing high-margin sales throughout the year as management forecasts elevated costs for European power consumption per Fig 3. These positive pricing trends are backed by the Met Office’s warning that
[this] year will be warmer than [the last] one, and one of the hottest on record
for the UK and presumably the rest of Europe.
Asia will see a similar earnings picture, except due to higher volumes, with an improved Chinese economic backdrop forecasting ~5% GDP growth. China is a key part of the region for the company, making up ~65% of Asia revenues in 2022. Fig. 4 shows there was a 7% y/y increase in volumes
despite COVID-19 impacts in certain parts of China
as alluded to in the 10-Q, meaning demand normalization has started but there is still substantial upside left. There was also a modest 7% increase in operating income and a 200 basis point expansion in operating margins, adding to the optimistic top and bottom line outlook.
It’s worth mentioning that currency headwinds were significant drawbacks from the double-digit growth Europe and Asia (-11% and -10% respectively) saw in their volumes + pricing + energy pass-through cost figures. However, stickier inflation has forced the Fed to reverse course on their softer economic policy, creating a favorable currency outlook moving forward. EUR/USD already dropped from its February exchange rate peak of $1.10 to $1.08, GBP/USD dropped from a rate of $1.24 to $1.22, but CNY/USD stayed at $0.15 after it slightly decreased to $0.14.
All of this is without mentioning the resiliency of the Americas in Fig. 5, which used a 9% increase in pricing and a 6% increase in volumes to create 13% higher sales y/y despite a recessionary overhang. The region also posted a 28% increase in operating income and a 300 basis point expansion in operating margins amid higher inflationary costs.
These major regional tailwinds push us to believe that Fig. 6’s earnings growth estimates of 9-12% are early and conservative, leaving room for upward revisions as the year progresses.
This dramatically improved earnings picture and positive macroeconomic news (relative to the company) make Q1 2023 seem more promising than it originally was on the surface, creating a questionable 15% decline in the stock.
Update on Upcoming Projects
Figure 7: NEOM Project Capital Needs (Air Products and Chemicals Q1 2023 Presentation)
Figure 8: Total Investment Capacity (Air Products and Chemicals Q1 2023 Presentation)
Figure 9: Quarterly Debt-to-Equity Ratio (Author, Stock Analysis)
The Saudi Arabian NEOM and Texas hydrogen plants, opening in 2026 and 2027 respectively, will be some of the world’s largest green-ammonia producers and represent the next stage of growth for Air Products and Chemicals. Vast international support for these carbon-free hydrogen and rapid government adoption of the end markets of these energy sources bode well, especially with the company locked into 30-year contracts that can provide growing, predictable cash flows.
Moreover, NEOM and the Jazan Industrial Gas Complex, one of the world’s largest oil refineries of which the company owns a ~50% stake, are part of a strategic plan to meet the Middle East’s future green energy demands and current industrial gas and oil needs. This will help to diversify Air Product’s regional presence (the Middle East represented <1% of sales>world’s fastest-growing major economy/region.
However, it must first deal with the financial obstacles brought up in the quarter. Fig. 7 shows that the total CapEx of NEOM expanded by $3.5B due to operating, inflationary, and financing-related costs, very much expected when building a project of that size in the current macroeconomic environment. Because the company only owns 33% of the hydrogen plant (Saudi-backed investment firm NEOM and Saudi-based ACWA Power split the other 66% ownership), they are only responsible for $1.2B of the CapEx increase.
Certain costs can be avoided, but we think the company should spend now on making NEOM more self-sufficient to lower future operating costs, creating higher-margin revenue and quality earnings as soon as the project opens up to the region.
While we forecast additional costs to also be a problem for the large-scale Texas green hydrogen project, Fig. 8 shows they are still within their $36.3B 9-year CapEx allocation plan and have $4.2B of capacity left ($36.3B – $26.9 spend and backlog – $1.2B additional capital for NEOM – $4B Texas plant = $4.2B remaining). If they did hypothetically use debt markets after reaching capacity, its debt-to-equity ratio of 0.62 in Fig. 9, while higher than previous quarters, still shows the company’s financial flexibility to tolerate debt should it access those markets.
Risks
Figure 10: Operating Cash Flow and Cash Flow Coverage Ratio (Author, Stock Analysis)
Figure 11: Quarterly ROI (Author, Stock Analysis)
One major risk is that higher pricing and energy pass-through costs will create demand destruction, worsening with potential recessions in America and Europe.
Although Fig. 2 did show some demand destruction in Europe with volumes declining 6% y/y as prices rose 14%, we must remember that energy is an inelastic good (% change in volume / % change in pricing and pass-through costs < 1), meaning price increases don’t have a significant change on demand. This was the case in Europe (|-6%/23%| < 1) and the Americas (|6%/8%| < 1) and we expect this to hold even if we enter a recession from late 2023 to early 2024.
Further alleviating concerns is that total sales also increase when demand for a good is inelastic and prices increase. As such we expect no material impact on the core business, making the company near recession-proof.
The other major concern is only having $4.2B left in capital mobility for their 2027 strategy, making it tough to exploit new growth opportunities; expand their presence in emerging markets; or navigate debt markets.
However, with two megaprojects slated to open within the next 4 years, we believe there is no immediate need to invest the money. Rather, it serves as a buffer to their spending limit in case additional costs arise like in the NEOM project. And while an argument can be made to prioritize the balance sheet, Air Products is in a comfortable position to execute its current strategy.
Fig. 10 shows the company’s cash flow coverage (operating cash flows / total debt, measuring the ability of operating cash flows to pay off debt) which has always been strong. There was a sharp decline from 2019 to 2020, but this was due to management doubling total debt by taking advantage of low-rate bonds to fund new ventures like their NEOM and Texas plants.
We can trust these capital decisions as the company has grown operating cash flows at a 5% CAGR since 2017, a number that should rise when new projects finish and begin making money. Additionally, in Fig. 11, they have consistently kept an ROI of ~20% over the past 6 quarters despite debt increasing by 12%, proving that the project debt they take on translates into earnings.
Moving Forward
Air Products & Chemicals is more than a singular missed earnings report that the market is punishing it for. With prudent liquidity management and major projects set to capitalize on green energy tailwinds, the company has created a bullish outlook to survive current economic conditions and thrive in the future. A choppy market environment has provided a great opportunity to accumulate a straightforward stock that can provide stability.
