Air Products & Chemicals - Nothing To Expect But The Dividend

| About: Air Products (APD)

Summary

APD is building several on-site facilities with contracts of 15-20 years with their clients offering great cash flow stability.

Management focuses on cash flow generation and now shows 33 years of consecutive dividend payment increases.

Its strong position in China for the Oxygen market and among U.S. gulf oil & gas companies has hurt APD recent results.

It can also become the reason for a bounce back.

DSR Quick Stats

Sector: basic materials

5 Year Revenue Growth: 1.86%

5 Year EPS Growth: 6.57%

5 Year Dividend Growth: 10.46%

Current Dividend Yield: 2.31%

What Makes Air Products & Chemicals (NYSE:APD) a Good Business?

Air Products & Chemicals Inc is a supplier of hydrogen and helium. It also provides semiconductor materials, refinery hydrogen, natural gas liquefaction and advanced coatings and adhesives. It is well diversified geographically:

Source: APD presentation

Air Products & Chemicals has been in business for the past 75 years. Its 750+ facilities are present in over 50 countries and they employ 19,000 workers worldwide. The company is part of the selective group of dividend aristocrats showing 33 consecutive years of dividend payment increases.

Ratios

Price to Earnings: 56.61

Price to Free Cash Flow: 30.66

Price to Book: 4.51

Return on Equity: 7.59%

Revenue

Revenue Graph from Ycharts

The overall lower energy prices affected APD's revenue in the U.S. Their latest quarter shows a drop of 17% for the Americas' segment while international divisions posted negative numbers as well due to lower energy prices and currency headwinds. At this time, APD is going through challenging times not to say the least!

How APD fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I've been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let's take a closer look at them.

Source: Ycharts

Principle #1: High Dividend Yield Doesn't Equal High Returns

My first investment principle goes against many income seeking investors' rule: I try to avoid most companies with a dividend yield over 5%. Very few investments like this will be made in my case (you can read my case against high dividend yield here). The reason is simple: when a company pays a high dividend, it's because the market thinks it's a risky investment… or that the company has nothing else but a constant cash flow to offer its investors. However, high yield hardly come with dividend growth and this is what I am seeking most.

Source: data from Ycharts.

While the dividend payment has never stopped increasing on the above mentioned graph, the stock yield has gone way below the 3% bar and it now currently around 2.30%. This can be explained by a stock price surge of 57% since July 2013. As the stock price continued to increase, the dividend growth rate wasn't strong enough to maintain a more appealing yield. Nonetheless, this is good news for investors holding the stock for a few years!

APD meets my 1st investing principle.

Principle#2: Focus on Dividend Growth

My second investing principle relates to dividend growth as being the most important metric of all. It proves management's trust in the company's future and is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can't be derived from anything else but increasing revenue. Who doesn't want to own a company that shows rising revenues and earnings?

Source: ycharts

With an impressive dividend payment streak of 33 years, APD has proven it can sustainably manage its cash flow and make sure shareholders are rewarded. Management continues to present cash flow as their main focus in their quarterly presentation as they believe long term cash flow is what brings value on the table. As a dividend growth investor, I can hardly argue with them! APD meets my 2nd principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what happened with a company. As investors, we are more concerned about the future than the past. this is why it is important to find companies that will be able to sustain their dividend growth.

Source: data from Ycharts.

If you solely consider APD's payout ratio when looking at dividend payment sustainability, you will automatically discard this company. At a 125% payout ratio, I must admit this is far from being interesting. But remember that dividend payments are not paid from accounting principles (earnings), but are paid from what is in the company bank account (cash flow). This is why I also consider the cash payout ratio which stands at a more reasonable level (68.55%). As management stated; cash flow is king. APD meets my 3rd investing principle.

Principle #4: The Business Model Ensure Future Growth

APD has built a strong relationship with U.S. Gulf refiners along with Canadian oil sand companies. Here again, we are currently in a down time for this business, but you can expect more business as oil prices are going up slowly. APD evolves in an oligopoly where 4 players control 80% of the market. Oligopoly markets are hard to find and offer a good shelter for companies evolving in them. It also helps companies like APD to enjoy high profit margins.

40% of APD revenues are coming from their on-site business model. This business model enables APD to build on-site facilities where its clients operate their business through long term contracts (roughly 20 years). It enables APD to sell its excess to other customers within a 100 miles radius. Over the long haul, this could lead to small local monopoly of gas supplies.

What Air Products & Chemicals does with its cash?

The company obviously uses its cash to distribute dividends to its shareholders. APD also uses its cash flow to build new plans and doing the maintenance of its 750+ facilities. The company is also expecting to spin-off the remaining of Electronic Material Division of Versum this fall. This would generate additional cash flow in a tax free manner.

APD has a strong business model and therefore meet my 4th investing principle.

Principle #5: Buy When You Have Money in Hand - At The Right Valuation

I think the perfect time to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn't mean that you should buy everything you see because you have some savings aside. There is a valuation work to be done. In order to achieve this task, I will start by looking at how the stock market valued the stock over the past 10 years by looking at its PE ratio:

Source: data from Ycharts.

When I look at a graphic such as APD's PE ratio, I get a bit confused. The company was once higher valued than 32.5 times its earnings and as low as 11 times during the same 10 years. At this stage, I can't really determine what the market thinks about the right valuation of APD. Nonetheless, any company showing a PE ratio over 20 is already not on the good side of a bargain…

In order to have a proper idea of how much APD is worth as a dividend growth stocks, I will use a double stage dividend discount model. For the first 10 years, I will use a 6% rate which is similar to their latest increase. Then, I will use a 7% dividend growth rate as I think APD is able to benefit from additional growth coming from China in the future.

Input Descriptions for 15-Cell Matrix

INPUTS

Enter Recent Annual Dividend Payment:

$3.44

Enter Expected Dividend Growth Rate Years 1-10:

6.00%

Enter Expected Terminal Dividend Growth Rate:

7.00%

Enter Discount Rate:

10.00%

Here are the results of my calculations:

Calculated Intrinsic Value OUTPUT 15-Cell Matrix

Discount Rate (Horizontal)

Margin of Safety

9.00%

10.00%

11.00%

20% Premium

$202.59

$135.52

$101.96

10% Premium

$185.70

$124.23

$93.47

Intrinsic Value

$168.82

$112.93

$84.97

10% Discount

$151.94

$101.64

$76.47

20% Discount

$135.06

$90.35

$67.98

Source:Dividend Monk Toolkit Excel Calculation Spreadsheet

As you can see, APD seems to be highly overvalued at this time. In order to have a proper valuation, I would need to use a 9% discount rate (intrinsic value at $168.82) but I find the company too dependent on external factors to become so generous in my valuation. APD doesn't meet my 5th investing principle.

Principle #6: The Rationale Used to Buy is Also Used to Sell

I've found that one of the biggest investor struggles is to know when to buy and sell his holdings. I use a very simple, but very effective rule to overcome my emotions when it is the time to pull the trigger. My investment decisions are motivated by the fact that the company confirms or not my investment thesis. Once the reasons (my investment thesis) why I purchase shares of a company are not valid anymore, I sell and never look back.

Investment thesis

Investing in a company evolving in an oligopoly is always a good move. APD can easily control its price and cost structure and slowly evolve with its competitors. Since the company is building on-site plants, it is building a stronger and stronger economic moat protecting their market share at the same time. The company shows growth factors through its strong presence in China and the fact it serves 90% of U.S. gulf refiners. In the event of an improved economy in China or an oil & gas recovery, APD will show better numbers and may become a very good investment.

Risks

APD is subject to greater volatility than its peers mainly due to the fact they are more exposed to the technological sector than their peers. Since techno companies are unpredictable, it is harder to show a steady trend in revenues for APD. While APD shows a strong business model, their financial performance has not always showed consistency.

APD shows a strong investment thesis and meets my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segment: the core portfolio built with strong & stable stocks meeting all our requirements. The second part is called the "dividend growth stock addition" where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

Having both segment helps me to categorize my investments into a "conservative" or "core" section or into a "growth" section. I then know exactly what to expect from it; a steady dividend payment or higher fluctuation with a great growth potential.

APD is definitely not the type of company you pick if you want to boost your portfolio return. However, this is the kind of company that will outperform the S&P 500 over the long haul. For example, APD's stock return outperformed the S&P 500 by 61% (total, excluding dividend payment) for the past 10 years. This is a steady growing company with a business model that is able to generate a strong and consistent cash flow. APD is a core holding.

Final Thoughts on APD - Buy, Hold or Sell?

In the light of this analysis, I can conclude that Air Products & Chemicals is a very interesting company built on solid grounds. I'm a bit reluctant to make an investment at this price, but I will certainly add it to my watch list. After all, it seems over priced because I have used a 10% discount rate instead of a 9% rate. APD is definitely a strong dividend stock for any portfolio.

Disclaimer: I do not hold APD in my DividendStocksRock portfolios.

Disclaimer: The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.

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.