Air Products and Chemicals (APD) recently announced a few transformative transactions in order to become a pure-play industrial gas business. While some of these actions have already been pre-announced in the Five-Point plan in September of 2015, definitive measures were announced in recent weeks.
The company announced the sale of its performance materials (PMD) division to German-based Evonik in a $3.8 billion deal. APD will furthermore spin off "Versum Materials," a new business which is comprised out of the current electronics materials business. Following these two transactions, APD will become a pure-play on industrial gases.
The PMD Sale
Air Products will receive $3.8 billion in cash for its performance materials business, to be paid by German-based Evonik. This German competitor has been actively looking to expand and diversify its operations. As the Germans have been eager to buy, it looks that APD received a good price for the business which produces epoxy agents, polyurethane and special additives.
PMD posted sales of $1.04 billion in 2015 on a trailing basis while adjusted EBITDA comes in at $241 million. This implies that Air Products has been able to sell the unit at 3.7 times sales and nearly 16 times EBITDA.
What Is Left Of APD?
While the PMD business will be sold, the EMD business will in essence be controlled by existing investors through the spin-off of that business. As a result, the valuation of that segment does not matter that much in the short run, as equity investors will not see a change in control of that segment.
The EMD business produced advances materials, process materials and delivery systems. The most important clients of these products can be found in the volatile semiconductor industry. This volatility makes it no longer desirable for Air Products as the core industrial gas business tends to be very stable.
Given the $3.8 billion cash proceeds from the sale of the PMD business, the pro-forma cash position is seen around $4.1 billion. Given the current debt load of $4.3 billion, APD is essentially unleveraged at the moment. Given the stable nature of the core operations of Air Products, the company has a natural capacity to take on quite some debt.
Note that APD posted sales of $9.9 billion in 2015. After subtracting the roughly $1 billion in sales from the PMD unit, pro-forma revenues are seen around $8.9 billion. The similar calculation learns that reported adjusted EBITDA of $2.98 billion will come in at roughly $2.74 billion going forward.
With 218 million shares outstanding, which trade at $143 per share, equity in Air Products is now valued at $31.1 billion. Given the lack of net leverage, the business trades at 3.5 times pro-forma sales and 11.4 times adjusted EBITDA. As the company has been able to sell its PMD business at higher multiples to Evonik, this once again reconfirms that the company has obtained a nice price for the PMD unit.
Ghasemi Does It Again
The strategy to become a pure-player has been initiated by Seifi Ghasemi, who became CEO in July of 2014. Investors had high hopes for the stock on the back of the announcement that Mr. Ghasemi would take the top job at Air Products. Following a momentum run surrounding his appointment, shares have risen some 10% between the summer of 2014 and today.
Investors and the Wall Street community like Mr. Ghasemi for the transformative work and value which he created as CEO of Rockwood, which eventually was sold to Albemarle (NYSE:ALB). At Rockwood, Mr. Ghasemi followed similar strategies as he is employing today at Air Products.
He is divesting non-core assets in which the company is not a leading player, actually divesting them at solid prices. These proceeds are then used to invest into the core business which is furthermore improved by stringent operational discipline.
Appeal Going Forward
The pro-forma business reported sales of $8.9 billion last year with EBITDA amounting to $2.74 billion. Given that APD's reported operating income for 2015 was equivalent to 63% of the adjusted EBITDA numbers, we can estimate the impact on earnings from the sale.
If we apply the same 63% ratio to the $241 million in adjusted EBITDA being reported by the PMD business, the sale will reduce pro-forma operating earnings by some $152 million. On the other hand, the $3.8 billion in proceeds from the sale could easily reduce interest expenses by roughly $100 million per year. If we add it all up, the impact on the net earnings is likely to be small.
While net earnings came in at $1.43 billion in 2015, pro-forma earnings could come in at roughly $1.4 billion, based on the dilution incurred from the PMD sale. This projection does not factor in the operational improvements which APD is targeting to achieve this year. At the release of the second-quarter earnings, APD guided for full year earnings of $7.25 to $7.50 per share. That actually suggests that earnings come in closer to $1.6 billion, with the difference mainly resulting from cost cutting efforts.
This is actually quite exciting for investors as the earnings outlook is not much impacted by the sale of the activities. The reduction in pre-tax earnings can largely be offset by a reduction in interest payments, or by a smaller float in the case of share buybacks.
All in all, APD is an unleveraged business following the sale of PMD. The company trades at 20 times earnings, 11 times EBITDA and 3.5 times sales. While the earnings multiple reveals a modest premium compared to the overall market, APD has a very strong balance sheet which actually has the capacity to take on quite some debt.
If you assume a modest 2 times leverage ratio, Air Products could take on $7 billion in net debt. That would allow the company to buy back some 50 million shares at current levels. Such a move could reduce the outstanding share base to roughly 170 million shares, although the company would incur pre-tax interest costs of roughly $300 million per annum in the process.
That means that projected profits could fall from $1.6 billion (based on the company's 2016 guidance), towards roughly $1.4 billion. These buybacks could add roughly a dollar to earnings per share, as earnings could total $8.25 per share in such a scenario. Based on these numbers shares would trade at 17-18 times earnings.
More Room Ahead?
If Air Products completes its transformation process and leverages up its balance sheet in order to engage in buybacks, the company trades at market-equivalent multiples.
That seems relatively attractive for a business which reports stable margins throughout the economic cycle. This margin stability is very well liked by investors, potentially allowing for some valuation multiple inflation. Another trigger to create value could of course be further M&A action in the wider industry, after some consolidation has already taken place.
Air Product's main US rivals are Praxair (NYSE:PX) and Airgas (ARG). The latter is of course the smaller competitor which last year was acquired by European competitor Air Liquide (OTCPK:AIQUY) in a $13.4 billion deal. That deal, which included a big 50% premium for the equity component, valued Airgas at 2.5 times sales, 14 times EBITDA and equity at 29 times earnings. Based on the valuation multiples being paid in terms of the earnings power of Airgas, more upside might be seen in case Air Products might be involved with industry consolidation.
Air Products is actually quite similar to Praxair, at least in terms of its size. Praxair is a +$40 billion business which trades at 4 times sales and 12-13 times EBITDA, marking a 10-15% premium in terms of multiples compared to Air Products.
So based on absolute and relative valuations, Air Products might see even better days ahead, even if shares trade just 5% from their all-time high in the low $150s. I consider shares to be fairly valued at current levels and would be quite aggressive on dips. As recent as January, market turmoil sent shares tumbling to just $115 per share. At those levels shares surely look appealing. If I target an entry point at 15-16 times potential earnings of $8.25 per share going forward, I end up with a targeted entry price at $125-$130 per share. At these levels I would aggressively start to accumulate some shares.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.