Pershing Square's Pressure On Air Products Will Bring Valuation In Line With Peers

Sep.16.13 | About: Air Products (APD)

Air Products & Chemicals (NYSE:APD) has already seen some lift from Pershing Square's activist campaign announcement, but I believe the coming two months offer additional upside with minimal downside. This article will lay out what we can expect in the coming months.

Company background:
Air Products distributes gases. Its main US competitors are Airgas (ARG) and Praxair (NYSE:PX). APD trades at $106 and has a market cap of $22 billion.

Activist background:
Pershing Square, led by Bill Ackman, is one of the few major activist investors that goes after large caps (along with Icahn Associates, Trian Partners, and a few others). Pershing Square has generally had an impressive record over the years in its activist investments, though its losers have managed to receive outsize media attention (see J.C. Penney).

Campaign background:
Our story starts with a July 8 Bloomberg article, reporting that Pershing Square was seeking to raise $1 billion for a single-stock fund. Pershing Square dropped hints about which company it might be targeting, but no one figured out it was Air Products ... except Air Products. On July 25, Air Products adopted a poison pill with a 10% trigger, in response to "unusual activity" in the company's shares. The company's stock had increased from $92 to $100 from July 8 to July 24, and on the 25th, the stock rose to $107 on speculation that Pershing Square was the cause of the "unusual activity."

On July 31, Pershing Square confirmed the Air Products investment, disclosing a 9.8% stake in a 13D. The company's stock hit a high of $111, but closed at $109 that day. Since then, Pershing Square has been quiet about its investment (distracting itself with well-covered soap operas at J.C. Penney and Herbalife).

What's next:
There are a few important dates coming up. First, Air Products is expected to report quarterly earnings in mid-late October (it last reported on July 23). Second, the proxy fight nomination deadline is October 26. And finally, the last annual meeting was on January 24, 2013, so expect the next annual meeting to be scheduled around the same time in 2014.

Expect Pershing Square to see what quarterly figures Air Products reports, and if it's not a blow-out quarter, then Pershing Square will nominate four candidates to the 12-person board (there are only four seats up this year, as the company has a staggered board). That rise in hostilities should produce a minor bump in the stock price.

Another potential outcome is an October settlement giving Pershing Square one or two board seats. That should also be seen as a minor positive by the market, giving Air Products careful oversight.

Model is Canadian Pacific:
Pershing Square most likely will frame its campaign as being similar to its fight at Canadian Pacific (NYSE:CP), which Pershing Square took board control of in 2012. In October 2011, Pershing Square filed a 13D there, with the stock at $60. In January 2012, Pershing Square nominated five directors (later upped to seven). The morning of the scheduled annual meeting, May 17, the board conceded to Pershing Square and gave the fund all the seats it was seeking. Pershing Square replaced the CEO, but didn't make any significant financial/strategic changes. CP's stock price is now at $120, and Pershing Square has announced plans to significantly reduce its stake (though it hasn't yet followed through).

This investment, like most of mine, is not about valuation, but rather about taking advantage of a short-term activism-related catalyst. But, valuation still matters, so let's see how Air Products' fundamentals stack up.

The company made $4.67/share in the last four quarters, giving it a 23 P/E, similar to Praxair's 22 and Airgas' 24. Let's note, though, that Air Products is expected to make $1.47/share this quarter, much higher than the $0.64 (GAAP basis) made last year in that quarter (thanks to a large write-down). If you calculate Air Products' annual earnings by including the coming quarter, we have $5.50/share, giving it a P/E of 19. With earnings of $5.50, given a P/E of 23, Air Products stock would be worth $126.50.

The industry-lagging P/E might be justified if Pershing Square were not involved, as Air Products is sometimes seen as having inferior management (return on assets and return on equity, for example, each fall behind ARG and PX). However, with Pershing Square (and the world) closely scrutinizing the company, Air Products' management will surely be making every effort to improve efficiency.

Air Products' multiples are currently weaker than peers. The combination of quarterly earnings in October and pressure from Pershing Square should bring the company's valuation up to match peers. Meanwhile, downside risk is low because any weak numbers from the company will bring a significant response from Pershing Square and other shareholders.

Disclosure: I am long APD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.