Description

The combination of accelerating revenue growth from projects where the capex has already been spent, improving ROIC, pricing power, and potential for a relative re-rating create a compelling investment case for Air Liquide. Moreover, the industrial gases business remains attractive with concentrated markets, take-or-pay contracts, and a steady stream of new outsourcing customers.

• Consensus’ myopic view of Air Liquide misses its operating leverage: I believe that it is not so much where Air Liquide is domiciled but where it is extracting value.  AI has the largest percentage of sales coming from Europe at ~53%, which has materially affected performance.  Europe is not only the opportunity:  AI owns the largest pipeline network in the all important US Gulf region and is starting to benefit from increase oxygen/nitrogen demand in the US.  In addition, the industrializing emerging markets is still going strong as evidence by the strong backlog of projects for next year.

• What the street is missing: AI gained share during the European down turn and its operating leverage will be more significant than most expect given that it has been through several rounds of restructuring already, as evidenced by its higher return on capital then peers.  Most areas AI sells gases into are pretty stable, like health care and midlevel industrial activity and even food production.

• Consensus estimates are too conservative given the sticky cash flows and entry barriers:  Company continues to grow organically, with little help from European base business because of strong pent-up demand in backlog.  New projects ramping up should add +5% to consensus organic revenue growth estimate of +7%.  Industrial-gas companies are the last unregulated utilities, generating reliable cash returns without price regulation. A significant proportion of their cash flow comes from installing industrial-gas plants at a client's site, on a take-or-pay contract. That means the customer must either take the product at the current price or pay the supplier a penalty. This guarantees revenue, but also means that Air Liquide is responsible for upfront capital investment, which creates a significant barrier to entry.

• Impact from drop in oil prices probably limited: Management does not expect a strong impact on its business if oil prices remain at current levels of USD60-70/b. Air Liquide's sales exposure to shale gas is <USD100m. It provides nitrogen and CO2 for the injection of water and chemicals to oil services firms (booked in Industrial Merchant). However, downstream chemicals industry is still there with lot of projects in the Gulf Coast and Air Liquide’s Large Industries are very active in this industry.

• Air Liquide should continue to grow:  The company reiterated that sales growth would accelerate to a 5-7% CAGR 2015-20 vs. 2010-20 (4-6%) despite lower capex budget (EUR10bn in 2015-20) as it has invested in larger projects in recent years, providing a reservoir for cash & sales generation. Thus, the capex/sales ratio will decrease. On M&A, it will carry out bolt-on acquisitions for which it applies an after tax IRR requirement of 12-13%, allowing it to maintain an after tax ROCE of 11-13%. China is still showing good opportunities in downstream chemicals as well as coal to chemicals (coal gasification=syngas, purification of CO2). There is no delay in projects in China. The company is selecting its projects on different parameters, with the quality of the customer's site is even more important than the quality of the customer. In contrast, healthcare is an opportunity to grow in mature markets. Volume growth is 7% a year in healthcare. This and a small acquisition (Gasmedi) lifted the number of patients from 1.1m in 2013 to 1.2-1.3m today.

The business:

Air Liquide provides oxygen, nitrogen, argon, hydrogen and carbon monoxide to the metals, chemicals, energy and refining sectors through a network of plants and pipelines. These included 342 large Air Separation Units (ASUs) producing nitrogen, oxygen and argon, 47 Steam Methane Reformers (SMRs) producing hydrogen and carbon monoxide and 17 co-generation plants producing energy and steam around the world. In the metals industry, oxygen is used to produce steel to improve energy performance and reduce emissions. The majority of new projects are currently located in developing economies. The chemicals industry uses mainly oxygen, hydrogen and carbon monoxide in its manufacturing processes, and nitrogen for the inerting of installations. The refining industry requires hydrogen to desulfurize fuels and break up heavy hydrocarbons. The demand for hydrogen is growing due to the combination of increasingly stringent emissions legislation and use of heavier hydrocarbons. Numerous firms in the energy or chemicals industries use oxygen to transform large quantities of coal and natural gas into syngas (raw materials in the production of chemical products) or electricity. To meet customer requirements, the supply of large quantities of gas is indispensable. Air Liquide supplies gas directly by pipeline from dedicated plants or through a pipeline network. Air Liquide has built its own pipeline networks progressively over the last 40 years. With a total length of more than 9,000 km, these networks stretch, for example, across northern Europe, from Rotterdam through to Dunkirk, and along the Gulf of Mexico in the United Sates from Lake Charles to Corpus Christi. Many other mid-sized local networks have also been built in other significant and fast developing industrial basins in Germany, Italy, Singapore and more recently, South Korea and China. The use of industrial gases is indispensable for these various industrial processes. As any discontinuity in the supply necessitates a stoppage of the customer’s production operations, supply reliability is crucial. However, although vital, gas supply generally represents a very small part of total production cost for the customer.  The raw materials necessary for the production of industrial gases vary according to the type of unit and the region. The production of oxygen and nitrogen requires air and a large quantity of electricity. Hydrogen and carbon monoxide production units mainly consume natural gas and little electricity. Cogeneration units consume natural gas and water. The energy and capital intensity of these industrial processes is generally significant. The supply of gas is generally contracted for 15 years. For certain specific projects this can be extended to 20 years. Within these contracts, the Group guarantees long-term service continuity and availability with respect to gas supply via a high-performing industrial solution. In return, the contracts include the indexation of input costs, mainly electricity and natural gas, and guaranteed payment levels through take-or-pay clauses.

 What will move the stock price

• Short term: February Q report and 2015 outlook: Expect continued turnaround in base business as I see acceleration in growth from flat in 3Q13 to +8% in 2014; ROIC should improve from 10% to 11%; Pent up demand for new business: Substantial backlog of nearly €3bn should ramp up sales of €1.5bn.  Margins should expand: Cost cutting initiatives should come through in the next several quarters contributing to margins by +10 to +15 basis points (1H cost initiatives help boost operating margins by +10 basis points, ahead of target)

• Intermediate term: Over the next six to 12 months: I expect major project announcements, as management indicated during a Q call that many were underway; positive updates on current project pipelines; and continuing improvement in the European macro environment.

• Long term cycles/themes: Two general themes: Capex cycle:  US oil shale boom demand is still strong despite recent oil price pull back.  Demand will continue to rise for industrial gases as crude oils get heavier and of poorer quality.  Companies need incrementally larger amounts of hydrogen from AI to strip out the impurities in the fuel; Healthcare expenditure cycle: The birth bubble in the US will start to have an impact next year. An aging population implies steady growth for health-care-related gas products, such as oxygen.  Late next year nearly 20% of US citizens will be over the age of 60.  (Some companies are taking action already in other industries, SCI buying largest competitor, LH buying competitors).

Risks:

• A large part of this assessment is on economic growth, and assumes prevailing exchange rates remain unchanged into the future. Needless to say, the performance of chemicals companies can be significantly influenced by changes in demand, in turn driven by changes in industrial growth and consumer spending. For Air Liquide, changes in the oil price could also have a significant effect as well as diverse foreign exchange movements. A decline in agricultural commodity prices would affect farmers' agrochemical spending, as would persistent and simultaneous adverse weather conditions in a number of regions across the globe. Long-term consumer resistance to genetic modification could hamper growth potential as well as any changes in regulation. Delay of product launches could have a similar effect. In this period of continuing consolidation, unexpectedly large dilutive acquisitions could have a downward effect on all our companies.

Why Air Liqude is cheap

• Very cheap with a 3 to 1 risk/reward ratio: Too much of a discount on Europe:  Air Liquide trades at a 2015 P/E of 21x on €5.40 expected earnings. A competitor, Linde shares trade around a 2015 P/E of 27x.  This is somewhat rare:  AI historically fetches a meaningful premium to Linde because its average return on capital invested is ~ 10%, compared with Linde's 6%.  Upside: Margin improvements, higher sales growth in US oxygen/nitrogen businesses; growth in the EU region could add to earnings which is not priced in.  A multiple of 19x earnings (still below historical high) generates €130/share on the incremental €1.50 in earnings over time. Down side: €85/share on historical yield.  Also, AI shares has never corrected more than -10% to -15% over the past 10 years (excluding the financial crisis).  I expect this limited volatility to continue. 

Catalyst

• February Q report and 2015 outlook

• Over the next six to 12 months: I expect major project announcements on positive updates on current project pipelines

• Capex cycle 

• An aging population implies steady growth for health-care-related gas products, such as oxygen.