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Industrial gas producer Air Products (NYSE:APD) may not have been successful in its attempted hostile takeover of competitor Airgas (NYSE:ARG), but it is taking the necessary steps to grow market share organically. With the stock down by 14.9% compared to shares of Airgas and Praxair (NYSE:PX) being up 36% and 10%, respectively, since 2008, now is an attractive entry point for investors as the macroeconomy starts to weigh in. In my view, Air Products is best able to weather the declining demand in manufacturing and industrial operations among its peer group.

The firm produces specialty and chemical gases, equipment, performance materials, and other basic materials for energy, industrial, healthcare, and technology clients. It previously attempted to takeover Airgas and led an activist campaign that successfully resulted in both three nominees getting elected to the competitor's board and the annual meeting being bumped up earlier in the year. The buyout offer was eventually withdrawn when Air Products' complaint to remove the target's poison pill was rejected. The transaction, had it gone through, would have benefited both firms through realizing a greater competitive position against Praxair.

In terms of revenue, historically, Air Products and Praxair remain in a close tie, dethroning one another's industry lead every other year. A leg up with Airgas would have helped, but at least the company has upwards potential with its cheap price. From a multiples perspective, Air Products is the most undervalued among the three basic materials firms. It trades at 12.6x forward earnings, while Airgas and Praxair trade at a respective 15.6x and 16.6x forward earnings. At the same time, Air Products also offers the highest dividend yield at 2.7% versus Airgas' 1.8% and Praxair's 2%.

On the operational side, the firm is exposed to substantial risk in margins and volumes growth. Operations in Europe need to be substantially restructured with cash flow bleeding in that region. A softening macro environment will have its greatest impact in terms of decelerating the Electronics & Performance segment for the first half of 2012. With that said, the company still has a backlog of merchant gas and tonnage that is worth over $12.5B and management is likely to increase capital expenditures by up to 30% in 2012. Taken together, this gives me much greater confidence that demand will nevertheless exceed expectations. Higher utilization rates coupled with improving margins - I model 29.5% gross margins by next year - will set the industrial gas company on the right course.

At the fourth quarter earnings call (see transcript), CFO Paul Huck noted:

"We had a strong year, with significant improvement in operating cash flow, up 15%. We increased our dividend for the 29th consecutive year, an increase of 18%. We repurchased $649 million of stock during fiscal year 2011 and announced a new $1 billion share repurchase authorization. And our adjusted earnings per share of $5.73 was up 14%, just above the high end of our original guidance range. On the sustainability front, we renamed the both the Carbon Disclosure Project and Dow Jones Sustainable indices, reflecting the results and leadership we are delivering in this important area…

Our underlying sales grew 10%, with volumes up 9% and price up 1%. We delivered good volume growth in a period of modest economic growth driven by strong performance on our Electronics and Performance Materials segment, which posted its second consecutive year of over 20% growth. Volume growth of 11% in Tonnage Gases, principally from new investments and contracts. And in our Merchant segment, growth in Asia was well above 20% with much more modest growth experienced in the U.S. and Europe. Operating income of $1.7 billion grew 13% mainly from better performance in Electronics and Performance Materials and Tonnage Gases segments".

During the fourth quarter, for the Merchant gas segment, performance in North America was weak, but offset by 30% growth in Asia - causing sales to increase by 10% overall. Going forward, I anticipate Merchant, Tonnage, Electronics & Performance, and Equipment & Energy, having roughly the same growth rates over the next few years. Praxair has less leverage to accelerate sales off of with net debt representing only 20.6% of market value compared to 22.9% of market value for Airgas.

My main concern with Air Products concerns its ability to boost margins. With growth margins of 27.4% compared to Airgas' 55% and Praxair's 43.1%, Air Products has a long way to go to fully maximize the potential of its leverage. Streamlining operations to key segments would be ideal given the sluggish demand in Europe and North America. In particular, the firm should shift greater attention to oxygen and hydrogen, where it is likely to experience sequential improvements in the years ahead.

Consensus estimates for EPS are that it will grow by 6.5% to $6.10 in 2012 and then by 11.1% and 8.7% more in the following years. Of the 16 estimate revisions, 13 have gone down. I model revenue growing by a CAGR of around 15% for the years 2012 and 2013.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Air Products Most Undervalued Among Peers