We believe Praxair (PX) represents attractive relative value versus its peer Air Products & Chemicals (APD), and propose a pair trade long PX – short APD. It is probably reasonable to expect PX to outperform APD by 15%+ over the next year or so.

PX and APD are both industrial gas companies. This is one of the most resilient and stable niches within the industrials space, as a high percentage (65%+) of sales is derived from take-or-pay contracts that last anywhere from 5 to 20 years. Besides stable demand that generally grows at GDP plus 2-3pct each year, margins are also remarkably consistent, as most of the volatile COGS items (diesel, nat gas, electricity) are contractually passed through to customers. Couple this with the fact that 70% of the global (non-captive) market is controlled by only 4 companies (PX, APD, AI FP, LIN GY) and you end up with a pretty good business model that can consistently yield high-teen ROEs.

PX is the best-run company in the space, with a clear ROIC advantage vs APD (13.0% vs 9.5% on 2014 ests) and much higher margins (32% vs 25%). The main driver for this difference is PX’s superior footprint that results in highly efficient operations. This might seem trivial but it makes a big difference, as it takes decades to build and would be extremely difficult for APD to replicate in the near-term. Industrial gas is a highly local business, given the difficulty to ship the gas long distances. There are virtually no imports/exports of industrial gases like nitrogen or oxygen, as transport costs would render them uncompetitive vs local production. To be successful in this industry, it is critical to be close to the customer, and the best way to exact efficiencies is to lay out a network of manufacturing/distribution facilities that are geographically close to one another. “Density” is the key concept here, and this is probably the main differentiating factor between PX and APD, and the result of decades of sound capital allocation and a disciplined approach to entering new markets. Its footprint in China as shown below is a good example.

PX’s superior returns on capital led to a historical 25% P/E premium relative to APD. This all changed after activist Pershing Square announced in late July 2013 it had taken a 9.8% stake in APD and would engage with the Board to drive shareholder value. That was nearly one year ago and so far little has changed within APD. The company announced on Sep 26^th that its CEO would retire in 2014, but a new CEO has yet to be appointed. APD has engaged an executive search firm and had set a soft deadline of June 30^th to announce the new CEO.

You could not tell how little (or no) progress APD has made in the past year by looking at its stock price. The company has closed the valuation discount vs PX and is currently trading at parity (on a P/E basis, 19.3x NTM EPS), in spite of an unchanged operational outlook.

We believe the current valuation implies blind faith in a new (yet unknown) CEO’s ability to transform APD and close the performance gap vs PX. The activist investor himself claimed there was “no reason” why APD’s margins should be 700bps below PX’s. We beg to disagree – as articulated above, PX’s operational excellence is largely the product of an efficient asset footprint that took decades to build. If APD is to pursue a similar strategy, this is clearly not something they will pull off in a year or two. In our opinion, there is little “low-hanging fruit” in turning around APD. Some have suggested APD could unleash value by MLP’ing its hydrogen pipeline in the US Gulf Coast. It’s hard to see such a measure providing much valuation uplift considering APD already trades at near 12x EBITDA, as the CFO recently admitted.

In summary, we perceive APD as being near “peak optimism”, with recent outperformance likely driven by the imminent appointment of a new CEO. As soon as the new CEO gets to work and communicating with the Street, we believe it will become apparent that APD’s turnaround will be tougher and slower than most expect, and as the stock becomes a “show me” story it should return to trading at a discount vs PX.

• APD appoints a new CEO and shifts into "show me" phase.