After a troubled merger attempt late this summer between Praxair (PX) and German-based Linde AG (OTCPK:LNAGF, OTCPK:LNEGY), both companies have finally agreed on the terms of a potential tie-up. While this marks an important step, a final deal still has a long way to go as regulators are not likely to give their blessing without modifications to the deal.
This uncertainty and unwillingness at Linde to cut costs casts doubt on the prospects for the merger which otherwise looks good, with the combination expecting a billion in cost savings. While the outlook for the combination looks solid, if a deal goes through and synergies are being deliver upon, I see no immediate appeal with the combination trading at 18 times pro-forma earnings already.
If uncertainty regarding the deal will weigh further on the shares I might buy into the investment thesis if shares start approaching the $100 mark, levels last seen early this year.
Merger Of Equals, No Cash Involved
Praxair is aiming to merge with Linde in an all-stock transaction allowing the new combination to operate without the involvement of additional debt.
Under terms of the planned transaction, Praxair will be the surviving entity as investors in Linde will receive 1.54 new shares of the "new" Praxair, as the ownership of Praxair's shares will be split equally, that is 50/50 across both companies.
One thing is clear, the merger process will involve a lot of regulatory scrutiny as the number 2 and 3 are combining their operations, in part in response to the acquisition of Airgas by current market leader Air Liquide. This planned merger would create the new leader in the global market for industrial gases, in a deal which probably involves some divestments in order to satisfy regulators.
Both firms tout the strategic rationale, driven by Linde's technology and Praxair's efficient operating model. Having origins in both US (Praxair) and Europe (Linde), this new player would get a lot more scale across the globe, creating diversification and room for efficiencies, as well as increased market power.
Scale synergies are the key driver behind an anticipated $1 billion in annual synergies, yet achieving them can be an issue as there is resistance within Linde to cut jobs in its home country. That being said, there is certainly potential to boost earnings at Linde as its margins lag those of Praxair to a huge extent.
How Fair Is The Price?
Based on the 2015 numbers, Praxair reported sales of $10.8 billion, operating profits of $2.3 billion and adjusted operating profits of nearly $2.5 billion. Operating in a capital intensive industry, Praxair operates with $9.1 billion in net debt, for a 2.5 times leverage ratio as adjusted EBITDA comes in at $3.6 billion a year.
Linde is much bigger, having reported nearly EUR 18 billion in revenues in 2015. The issue is that while sales are nearly 2 times as large as those of Praxair, Linde is not much more profitable in absolute dollar terms. Reported operating profits come in at little over EUR 2.0 billion, with adjusted operating profits barely surpassing EUR 2.2 billion. While sales of Linde are nearly twice those of Praxair, actual earnings are rather similar on the back of margins of merely 12%, surpassing the superior 23% margin reported by Praxair.
While it is true that part of this margin discrepancy can be explained by Linde having a low margin engineering business with EUR 2.6 billion in sales, this can only explain a relative small portion of the gap.
As such, the deal can be rationalized by investors in both companies. While Linde is bigger in terms of sales, its margins are lagging in a big way. With the 50/50 stock component of the deal, one thing is clear; that is deal related synergies benefit both parties.
Praxair ended the third quarter of this year with 288 million shares, as Linde has 186 million shares outstanding. Given the 1.54 exchange ratio, Linde's investors will hold 287 million shares in the new Praxair which will operate with 575 million shares outstanding. Shares of the company fell from $123 to $118 upon announcement of the financial merger details, wiping out nearly $3 billion in shareholder value despite the promise of $1 billion in synergies.
Praxair is on track to post sales of $10.5 billion this year, as revenues were finally growing again in the most recent quarter. If we generously use the adjusted metrics operating earnings are seen at $2.3 billion, for a $3.4 billion EBITDA number. Net debt stood at $9.2 billion at the end of the quarter.
Linde is on track to post sales of roughly EUR 17.5 billion this year, equivalent to $18.2 billion at current exchange rates. Adjusted operating earnings are seen at EUR 2.2 billion, or $2.3 billion in dollar terms, with EBITDA reaching $4.1 billion this year. Net debt stood at EUR 7.2 billion at the end of the third quarter, roughly $7.5 billion.
As such the combined business is on track to post sales of roughly $28.7 billion this year. Combined adjusted EBITDA is seen at $7.5 billion, supporting a $16.7 billion net debt load. With no cash payments involved in the deal leverage ratios are very limited at 2.2 times, as leverage ratios fall towards 2 times if synergies are taken into account.
Adjusted operating earnings are seen at $4.6 billion without taking into account synergies. Assuming a 3% interest rate on $16.7 billion in debt, interest costs are seen at $500 million. Assuming a 25% effective income tax rate, after-tax earnings are seen at nearly $3.1 billion.
With 575 million shares outstanding, that yields a $5.35 earnings per share number on a pro-forma basis. The kicker has to come from synergies which are seen at a billion. This number is equivalent to merely 5-6% of the annual sales reported by Linde, while the margin gap with Praxair is still 11%. Upon full realization of those promised synergies, pro-forma earnings could rise from $5.35 per share towards $6.65 per share.
At a current levels of $118, that would result in an 18 times multiple, supporting a stable 5.5% earnings yield.
Final Thoughts, Some Potential Amidst Elevated Deal Risks
The deal makes a lot of sense in my eyes. Praxair's investors are getting a fair deal by partially owning a firm which is much larger, yet has a real margin struggle ahead. The potential billion dollar cost saving number is potentially very lucrative. If we capitalize this pre-tax number at a 20 times multiple after taking into account taxes, synergies could be worth $15 billion if being delivered upon today, equivalent to roughly $25 per share, including the newly to be issued shares.
The synergy targets looks realistic on the back of the margin gap, yet the Germans are reluctant to restructure their business, making it hard to deliver on job losses, thereby creating some integration risks. The timing now seems favorable for Praxair to step in however. This comes after Linde's CFO left in September and its CEO is set to depart this spring, creating a real leadership vacuum at Linde, giving leverage to Praxair of course.
That said the deal will probably involve some issues, as Linde is currently the second largest provider of industrial gases and Praxair is number three, creating a giant with potentially a bit too much market power in some businesses/geographic segments. The distraction and uncertainty has the potential to weigh on shares, certainly if some businesses will have to be divested at non-compelling multiples. If such uncertainty creates a further sell-off in the shares of Praxair, potentially retracing towards the $100 mark, I would be eager to step in and pick up a share in a business which is very stable and well-run.
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