|Shares Out. (in M):||1,890||P/E||0||0|
|Market Cap (in $M):||750||P/FCF||0||0|
|Net Debt (in $M):||1,450||EBIT||0||0|
This is a zero or hero trade that depends on Chinese stimulus / rebalancing to a great extent but has not rallied alongside other steel companies. I also need to submit a pitch for the VIC quota so here's some food for thought.
The Company is Yingde Gas listed in Hong Kong. #2 market share in China, ~$750 mm USD market cap w/ a $1.5 Bn debt load, roughly 4-5x Net Debt / EBITDA levered, minimal cash flow due to continuous project built-outs in China. ~80% of company's revenue is based on long-term take or pay contracts (international peers 20+ pts lower) but critically, most of its customers are steel mills taking its oxygen and many of them are SOEs. The company currently trades at 6x next year EV/EBITDA and the big 4 industrial gas guys trade at 10x+. The equipments the company uses isn't that much different vs. peers, but the company is currently priced at ~80% of invested capital. Its euro dollar bonds trade at 70 cents. Stock basicallt kept going down since USD strengthened in 2014 and oil collapsed and basically market believes this company is going to go belly-up. To make the matter worse, China's industrial gas market isn't that rationalized like the US / EU -- infact it's very much like the US back in the 80/90s, also a bunch of its customers refuse to pay Yingde (exhibited by the balooning receivables and low / negative FCF despite EBITDA growth) and comically, one of its customers actually raided & took over the gas plant (All take no pay, only in China).
But of course, industrial gas isn't only about oxygen. Nitrogen & rare gas components drive a lot of major 4 gas players' margin these days and China will be no different. The local moat becomes very entrenched upon a sizable precense, and importantly China is certainly the next big frontier for meaningful growth as consumers spend more dollars on all sorts of things. I believe Yingde is bound to attract strategic interest in some shape or form -- but I don't know whether it's gonna be via equity (which will be sweet) or bonds + restructuring (like APD / PX buying all the bonds and driving the company bust). One thing is for sure though, in a few years, given the importance of industrial gas sector and the value of its assets, Yingde will either be a 5-10 bagger from here (as China manages the rebalancing), goes BK, or gets taken out in some shape of form. A small position size as a flyer is also not a bad way to speculate China keeps the stimulative game running.
The DB Jan 2013 Initiation is pretty good. Also here is some industry background I wrote up a while back that still applies.
1. Industrial Gas
- This lifeblood of industrial production exhibits utility-like characteristics and should deliver 10-13% equity return going forward deploying capital. Not very exciting but could have idiosyncratic upside if at mid-late cycle, have management driving change / doing deals.
- Historical competitive advantage was fortified by equipment / production / transportation know-how & efficiency + localized business driven by logistics, all of which contribute to lower marginal cost per ton vs. closest competition and ensure good IRR.
- The second competitive advantage is that air is separated into not one, but many, products. The rise of demand for all types of gases and emergence of heavy-gas-users (like steel, fertilizer, etc) gave rise to the economic flywheel combining (a) sizable on-site production and (b) a dense local logistics coverage:
o Large on-site ASU is the lowest cost of production and makes rare gas economically.
o A dense local coverage allows for high co-product uptake and high wallet share. Large on-site projects allow a firm to supply to these customers at the lowest possible cost.
o High-uptake increases the on-site project’s theoretical IRR, allowing the firm to bid on on-site projects more competitively and still realize a good return.
o As overall demand grows and a firm wins more on-site projects and increases density. This leadership position strengthens.
- Given the 2 characteristics above, the local champions remained dominant through-out history – the top 4 players in any key regions never fell out of ~60-70% share. In the US in particular, the top 4 players should occupy ~90% volume share when the AL-ARG deal closes.
- Volume growth comes down to GDP+. Aside from “more stuff”, there is also using more gas for certain applications balancing out the overall mix, new applications, continued trends of outsourcing, and consolidating local distribution. The industry historically grew top-line at 4-7% clip per annum deploying capital.
- The going-forward IRR on the stock is likely 10-13%. Industry rule-of-thumb points to 15% IRR on-site projects with 300-500 bps boost if co-product monetized well. Firms like APD and PX deploy ~50% of (OCF – maint. CapEx) to these projects, yielding ~7-8% return – or 9-10% assuming maintaining 1.5-2x leverage, the rest is returned to shareholder mostly via dividend at 2-3% yield. Historical ROIC / ROIIC benchmarking bootstraps this heuristic.
About 140 years ago, the industrial gas industry was born as the technique in liquefaction and air separation was invented by Carl Linde (Founder of Linde) and Georges Claude (Founder of Air Liquide). The industry, first supplied oxygen for street & in-house lighting needs, quickly found a solid growth path in 1895 for metal works – the discovery that a mixture of acetelyn and oxygen could produce a flame of up to 3,200 degrees Celsius, the highest temperature that had been attained by human artifice up the that time. The industry’s growth was turbo-charged as the 1st and 2nd world-war came to be and as the Heylandt storage technology of liquefied gases was invented in 1920 – and quickly grew from a hyper-localized, air-in-cylinder-forwarding mom-and-pop operation to the hub-and-spoke model with centralized, large-unit production more akin to the model we see today.
Fast forward to the 1950s, the industrial gas industry was still a high-tech one married with necessity of logistical density. The dominance of individual national champions comes from considerable investments made in setting up its own distribution systems and regional manufacturing plants running at high capacity. National dominance was reinforced by transactional agreements not to compete for business in each other’s domestic markets. The Swedish AGA dominated Scandinavia (>90% market share), Linde and Messer in Germany (40% share each), Air Liquide in France (>80%), and BOC in the UK (~95% share). Even in the United States, Union Carbide’s LAP and Airco together owned >80% of the market.
The increasing usage of nitrogen and larger, centralized air-separation-unit, however, brought APD to the center stage of market disruption -- for one thing, some users, especially in steelmaking, chemicals, and petroleum-refining, began to consume such quantities of air gases that it made economic sense to construct an on-site ASU to supply an individual factory or plant…large scale production of air gases allowed recovery from ASU of greater quantities of argon as well as neon, krypton, and xenon; all of which also sold for much higher prices than the “commodity” air gases.
APD in the US saw this opportunity and pioneered the “take-or-pay” structure. The assistance of financing, reduction of transportation cost, coupled with focusing and capitalizing on often ignored nitrogen + rare gases with good service allowed it to be the lowest cost provider in any market it enter – and helped it capture sizable share in the British market against BOC and entered Europe in the 1960s – breaking the cozy monopolies at the time. The rivals quickly responded, copied the model, and retaliated by entering the US market – thus marked the heavy competitive and merger phase of the 70s/80s.
The fierce market entries, levered mergers, and sizable growth of end-market volume and applications marked the 80s/90s period and left many players somewhat financially constrained into the end of the decade – and allowed Linde, the most conservative but technically superior player, to seize its opportunity in the 2000s by buying the 2 largest rivals (BOC and AGA). As we enter 2010s, the global industry was left with 4 big players of size (Air Liquide, Linde, Praxair, and APD). There had also been a profound change in the product palette – with now 20k or more gas mixtures. Importance of Nitrogen continues to grow, with H, CO2, and He performing well above average. Now the general rule of thumb is that – more developed a country, higher the % of nitrogen and special gases.
Specific Industry Competitive Characteristics & Go-to-market strategies
Ever since its existence, the industrial gas industry had been regional and oligopolistic / monopolistic at heart. The route density and technical know-how allowed this advantageous status in its nascent years, and the strong economic advantage with co-product density allowed this advantage to be more-or-less preserved to this date.
- With setup know-how and local power source, a company can ensure lowest cost delivery – thus pricing the project at decent IRR (~10-15%) accordingly and out-compete all other supplies.
o A larger on-site project also grants economy of scale in power & labor + effective monetization of rare gases with low parts-per-million (ppm). With reasonable credit spread, tight cost control, and best practices, ROE can be a bit higher in the 20% range.
- Importantly, a customer plant typically can’t necessarily take all the products made during the separation, thus the by-products (for example, nitrogen in the case of steel mills, oxygen in the case of fertilizer plants) will be distributed to other local customers via bulk & cylinder shipping.
o Such possibility will almost certainly affect the initial bid of ASU – big peripheral opportunity translates to ability to bid more aggressively on-site. This dynamics of selling-byproducts-by-necessity also to a large extent prevented customers from in-housing the gas production given the lack of local distribution, equipments, and relationships.
o An industrial gas supplier will study a regional market prior to construction of on-site facilities and then over-size capacity to account for regional liquefied gas demand to maximize co-product economics.
o Additionally, a competitive ASU on-site add would likely hurt peripheral gas profit as additional non-utilized gases get added to the market. The development of bulk-shipping technology worsens this situation.
o Nonetheless, an on-site supply IS the lowest cost supplier to the plant.
- At the bulk and cylinder level, it becomes a cost-plus and route-density logistics problem, just like the old days.
o The marginal cost is highly contingent on (1) the density of the coverage area – more dense = less delivery to more customers = lower cost / metric ton, (2) the technology behind the transport (purity, evaporation, liquid-form), and (3) wallet share of the customer + co-product up-take.
o In a two/three player market, the bulk merchant segment can get very competitive. Securing good margin becomes a function of sphere of influence (200-300 km), servicing & on-time delivery, and competitive on-site builds – as the additional co-product can definitely disrupt the market pricing given the potentially high incremental margin.
o Nonetheless, the regional bulk pricing will very likely be a cost-plus model of transportation + electricity + equipment amortization. The cost-curve is more staggered on the cylinder-front given the last-mile density + servicing nature.
- Hence, once a company occupies several on-site capacity in a region with a dense network – all underwritten at a reasonable IRR (15-20%), it becomes very uneconomic for competitive entry
o Incumbent can likely to bid very competitively for new on-site projects given the regional density & established relationships and still earn an excellent IRR thanks to co-products.
o If a new entrant wins one on-site – likely at a loss, it has to make its IRR via co-products. Given its lack of distribution presence, however, the marginal cost of bulk / cylinder delivery is likely very high unless the customer is near-by.
o Hence – with the exception of a sizable growth spurt in a region, it is uneconomic and unlikely for an organic competitive entry to an incumbent market. Another possible way of entry is by providing small-capacity, highly specialized service / gas applications.
- The lack of supplier (air is free and equipment is often sourced in-house / from fragmented manufacturers), broad-spectrum of fragmented customers, high start-up cost for on-site builds (ASU complexes can cost 60-100 mm+ with 3-year lead-time), lack of substitutes, and the co-product & route-density-driven dynamics described above makes this industry a rather favorable one in terms of competitive advantage for existing players.
Industry Concentration & Key Players
Most industrial gases are not traded across borders and oceans like traditional chemicals (except for some very expensive rare gases). Most industrial gas players are not yet truly global with exposure to key regions still missing –such as Air Products (Europe, part of Latin America and Asia), Praxair (parts of Asia, Europe), Airgas (Europe, Asia, Latin America), Air Liquide (parts of Asia, Latin America) and Linde (low exposure to North America other than in healthcare gases).
The wave of consolidation in the industry in the late 1990s and early 2000s further concentrated the industry and the industry’s highly consolidated nature has been a key factor reducing the possibilities for consolidation. The top five players now account for 78% of the global market compared to 51% in 1980 – and the potential combination of Air Liquide and Airgas will bring this to ~84%.
To further illustrate the point of “local” oligopolies – see below for the historical volume concentration of the US market. The on-site market is mostly captured by the Big 5, leaving any local bulk / cylinder business to the distributors that remain, the top share holder of which is Airgas with 25%.
Further global mergers are unlikely for anti-trust reasons but piecemeal disposal of non-core businesses and local scale consolidation is still possible, but on a much smaller scale than in the past decade. A medium-term possibility is the acquisition of Ying-de Gas (2168 HK) given the opportunity it would provide someone to gain scale in this important market. Although a merger of this name with a Chinese player looking to gain scale is an equally viable option.
One can think of the end-demand for industrial gas as ¼ metals-related, ¼ chemicals & manufacturing related, 10-15% each allocated to O&G, semiconductors / electronics, and healthcare, and the rest for everything else. In other words, one can tie its volume pretty close to industrial production and general global GDP growth – facilitated by growth CapEx spend about 5-6% of sales. In other words, the capital intensity of the industrial gas business is fairly high – rationalizing routes, cutting cost, and increasing wallet & co-product share can only get you so far on bottom-line growth, a firm has to deploy capital in building new on-site projects to match / exceed its top-line to GDP growth. Historically the players realized GDP + 200/300 bps. The capital deployment + continuous co-product sale + consolidation made the industry’s sales growth profile remarkably resilient – the financial crisis peak-to-trough was only about negative 5-10% across global players.
Looking forward, the value drivers for industrial gas companies are as follows:
- Increasing GDP growth and demand for more goods, leading to local capacity add and consequently demand for on-site production and bulk industrial gas.
- Increasing usage of nitrogen and rare gases (as opposed to oxygen) in developing countries will rationalize pricing and facilitate volume growth.
- New applications for gases will continue to drive demand growth.
- Continued trends of outsourcing will drive penetration.
- Consolidating local distribution.
Value Creation Formula
Industrial gas companies historically compounded at 10-13% annually for shareholders including ~1.5-2% dividend pay-outs and via ~1.5-2.0x Net Debt / EBITDA leverage. The bulk of this return originates from 5-6% sales growth and the corresponding slight margin expansion as the footprint matures, but this driver had meaningfully slowed in recent years vs. the late 90s – partially due to pricing and FX headwinds while volume trends remain at 3-5%. Evidently, there is little multiples expansion, and shareholder return venues beyond dividends is sparse when it comes to repurchases – perhaps rightfully so given the constantly high multiples (~16-22x PE after 2000s)
The rule-of-thumb by the industry is ~13-15% IRR for on-site projects – which could be brought higher to ~20% if the co-products are well-monetized in a rational market. The historical ROIC and ROIIC of the industry below to an extent confirms this view – and as long as the industry continue to see growth projects in emerging countries with similar return profiles, one can reasonably expect the similar 10-13% IRR on the stock going forward assuming no multiples compression (the heuristics being of the OCF – Maintenance CapEx, 50-60% goes towards 15%+ IRR projects returning ~7-9% and the rest goes towards dividends yielding 2-3%).
It is unlikely that these industrial gases companies take up leverage – a strong credit profile is quite important in winning long duration on-site projects. We could see a few points here and there given cost cuts, new applications, and better co-product monetization, but net-net this sector is as close to utilities / MLP as one can get to in the industrial / chemical space.
- Health of existing take-or-pay customers
o Anchoring one’s on-site plant with an uncompetitive player is a problem – especially so when the general area faces some serious headwind like Detroit during / before the financial crisis and/or Pittsburgh when the steel / coal industry falls apart. Not only could the asset itself be stranded, but the fall in gas demand in the area further pressures the return / margin.
- Emergence of industries that can internalize majority of on-site production.
o This is more of a thought exercise – but if a new industry shows up that can utilize almost all the gas produced by an ASU, there is a high likelihood that the supply / demand balance of the gas industry could be broken as this burgeoning area internalizes & becomes a competitor.
- Potentially low ROIIC projects in emerging markets to gain share
o All the players are very disciplined in this regard, but if there is one area where the current big 4 could get aggressive, it would be in the emerging countries to establish a strong on-site foothold + dense distribution network for future benefits.
- Lack of total returns
o 10-13% without multiples expansion is not very exciting – especially against the current industrial backdrop and issues in the global steel and fertilizer sectors. A big part of this sector’s utility-like valuation support hinges on long-term ROIIC assumption of ~15%, low cost of capital, and 1-2% pricing/volume/mix growth to tag along GDP/inflation.
- Emergence of better delivery medium could pressure returns
o In the sense that CapEx spend is necessary industry-wide to remain competitive – thus decreasing FCF in the interim but not necessarily contributing to returns over time.
Haven't done enough work to figure out.