Pulling Profits Out of Thin Air

Industrial gas producers’ strong records highlight the importance of economic moats: All three industrial gas companies we cover-- Air Liquide, Air Products, and Linde--have consistently earned excess economic profits despite selling what are essentially commodities. The industrial gas sector benefits from high switching costs and long-term customer agreements, which often include take-or-pay clauses and indexed electricity costs. These favorable contracts allow the companies to carve out economic moats that help them consistently generate strong and relatively stable cash flow streams. We believe that all three public industrial gas companies we cover will continue to outearn their cost of capital throughout the next decade, thanks to their narrow economic moats.

Industrial gases typically account for a relatively small fraction of customers’ costs but are a vital input to ensure uninterrupted production. As such, customers are often willing to pay a premium and sign long-term contracts to ensure that their businesses run smoothly. Long-term contracts and high switching costs contribute to industrial gas producers’ moats, helping them generate a predictable cash flow stream and lucrative returns.

Industrial gases are distributed through three supply modes: on-site, merchant, and packaged. Operations are often tightly integrated across all three supply modes. An industrial gas company will build an on-site plant (either adjacent to a customer’s facility or connected through pipelines) and sell excess capacity through merchant (tanker trucks) and packaged (cylinders and dewars) supply channels.

Switching costs vary by supply mode. Packaged gases are essentially commodities without any switching costs. Merchant customers, on the other hand, do face switching costs, as they typically enter into three- to seven-year contracts and often rely on industrial gas companies for storage and vaporization. The on-site segment has the highest switching costs, because switching to another supplier might require a substantial cost to convert or purchase new equipment. Large customers often sign 10- to 20-year contracts with take-or-pay clauses and prices indexed to the cost of electricity, and we estimate that customer retention rates exceed 95%.

As industrial gases are relatively inexpensive to produce, transportation costs often account for a large fraction of total costs. Therefore, industrial gas distribution is largely a regional business, as merchant gases are typically sold within a 200-mile radius from a production facility. This often gives entrenched industrial gas producers a near monopoly on the region, creating a significant barrier to entry for potential competitors.

Last but not least, as on-site customers are typically large facilities (such as steel or petrochemical plants) that are designed to operate around the clock, any production downtime required to switch to another distributor would be costly and acts as a strong deterrent to switching. In major industrial hubs, industrial gas companies have extensive pipeline networks linking multiple production facilities that they operate, and this redundancy greatly enhances reliability. Because of this integrated network, industrial gas distributors can guarantee uninterrupted supply to their on-site customers even if outages occur at any given facility.

In addition to switching costs, the moats of all three public industrial gas companies benefit from intangible assets, consisting primarily of customer relationships and patents. Industrial gas companies often develop strong relationships with their on-site customers, as they offer a full spectrum of engineering and consulting services. They can create value for their customers through optimization programs aimed at improving throughput rates, enhancing quality, and increasing safety. These on-site services and proprietary know-how help industrial gas distributors foster strong relationships with customers and contribute to very high customer retention rates. Furthermore, all three industrial gas majors have extensive patent portfolios (with Air Liquide owning more than 11,000 patents, Air Products more than 3,000, and Linde more than 6,000), which support their moats.

All three public industrial gas companies earn between 60% and 80% of their revenue from businesses we view as moaty. This business mix results in a strong and relatively stable cash flow stream, as long-term agreements in the merchant and on-site segments often include provisions that hedge industrial gas companies against changes in volume, pricing, and input costs.

Moats Help Deliver Consistent Returns Throughout Economic Cycle Because of industrial gas companies' geographic diversification and exposure to a broad range of industries, demand for industrial gases depends on the overall health of the world economy. Industrial gas volumes have a strong correlation to industrial production; over the long run, they tend to increase roughly in line with industrial production growth in developed economies and at about 1.5 times industrial production growth in developing countries. As such, industrial gas stock prices tend to directionally follow the industrial production index.

Despite an average level of cyclicality, Air Liquide, Air Products, and Linde have all consistently earned excess economic profits throughout the last decade thanks to their narrow moats, with returns on invested capital dropping slightly below our estimated 8% weighted average cost of capital only after a major merger or acquisition. However, we view those years as anomalies due to the immense size of the transactions and the costs of restructuring. We forecast returns on invested capital for all three companies to remain strong, as we expect Air Liquide and Linde to expand their operating margins due to synergies and think Air Products can sustain its improved margins and increase volumes through major acquisitions over the next five years.

Customer agreements in the merchant and on-site segments often contain certain provisions (including take-or-pay clauses, inflation-indexed prices, and pass-through of electricity costs) that partially hedge industrial gas companies against market fluctuations. As a result, all three publicly traded industrial gas companies have outearned their cost of capital throughout the last decade, even during the Great Recession. This solid performance illustrates the importance of economic moats, as they allow industrial gas companies to enjoy relatively stable cash flow streams throughout the economic cycle.

Consolidation Has Shifted the Industrial Gas Landscape The industrial gas industry has undergone a major wave of consolidation in recent years, as exemplified by Air Liquide's acquisition of Airgas in May 2016 and the Praxair-Linde megamerger in October 2018. These transactions created by far the two largest industrial gas companies in the world (with 2018 pro forma revenue of roughly $27 billion for Linde and $23.5 billion for Air Liquide), leaving Air Products a distant third in terms of market share (with calendar 2018 pro forma revenue of about $9 billion).

All three companies enjoy dominant market positions with a strong presence across all key regions. Our industrial gas forecasts are predicated on an assumption of continued moderate growth of the world economy. We project average core volume growth of roughly 6.5% per year, which reflects the industry’s long-term volume growth rate of approximately 1.2-1.4 times the growth in global industrial production plus inflation. We forecast low-double-digit revenue growth in Asia, Africa, and the Middle East, fueled by core volume growth, bolt-on acquisitions, and investments in new projects. Thus, we expect these regions to account for a growing portion of industrial gas companies’ sales.

Industrial gas suppliers are also relatively well diversified across end markets, serving a wide range of industries. It is notable that cyclical industries (including metals, energy, and chemicals) account for more than half of revenue. Nevertheless, industrial gas companies’ exposure to these cyclical industries is somewhat mitigated as they also account for a majority of on-site customers. As such, long-term customer agreements with take-or-pay clauses, inflation-indexed prices, and electricity cost pass-through provisions partially hedge industrial gas companies against exposure to market fluctuations.

Competition Will Keep Lid on Prices, but Lucrative Returns Should Persist Although all three public industrial gas companies have narrow moats and can pass through electricity costs to customers (in fact, contract prices are often indexed to electricity costs), we believe they are unlikely to meaningfully benefit from further price increases in the near future. In many key regions, especially in developed countries, gas supply is already abundant, and we view price increases significantly above inflation as unlikely. Additionally, we think that competition for new contracts in emerging countries (especially China and India), both among the industrial gas majors and from regional producers, is likely to keep a lid on pricing, as companies have to offer competitive bids to win new business in fast-growing economies.

Furthermore, on-site customers are often large companies that account for a significant portion of demand in a region and have the option to produce industrial gases in-house, which gives them strong negotiating power. In fact, roughly 30% of the global industrial gas market is captive (in-house production). While sourcing gases from industrial gas distributors typically offers enhanced reliability, engineering support, and relatively lower prices, the option to produce in-house acts as another check on pricing.

Finally, industrial gas companies continue to face pricing headwinds in the healthcare segment, especially in the United States but also in Europe. We expect pricing pressure from government agencies and insurance companies to persist in the near term as these institutions work to keep medical inflation at bay. As such, we project that revenue growth in the healthcare segment will be fueled primarily by patient growth and bolt-on acquisitions.

Although we project limited upside in pricing, we expect industrial gas companies’ returns on invested capital will remain high due to a favorable industry structure. As industrial gases represent a relatively small fraction of total costs but are a crucial input in many businesses, customers are willing to pay a premium and sign long-term agreements with reputable industrial gas distributors to ensure uninterrupted production.

As we see limited upside in pricing, we expect industrial gas majors to focus primarily on volume growth and operating efficiencies. This trend is evidenced by the recent consolidation wave, Air Products’ ambitious capital-deployment plan, and impressive margin expansion for all three companies. As Air Liquide, Air Products, and Linde all have narrow moats and are leaders in a highly profitable industry, we are confident that all three will continue earning excess economic profits throughout the next decade.

Air Products Our Favorite of the Three Air Products is currently our favorite pick in the industrial gas sector. New management has drastically improved profitability, and we think the company's growing emphasis on on-site business will improve the durability of excess returns. We think the current share price does not fully reflect future earnings from projects we expect to come on line over the next few years.

When he took the reins in June 2014, Seifi Ghasemi unveiled his five-point plan to transform the company by focusing on safety, profitability, core business, a clean balance sheet, and at least 10% annual earnings per share growth. Thus far, management has delivered on all these promises. Over the past few years, the company has improved its employee lost-time injury rate by 75%, raised EBITDA margins by over 1,000 basis points, divested noncore segments, significantly reduced debt, and delivered average annual EPS growth of roughly 14%. We attribute the improvement in margins largely to divestments of low-margin noncore operations as well as a widespread restructuring that resulted in significant cost cuts. EBITDA margins improved from 23.4% in 2014 to 34.9% in fiscal 2018, and we forecast they will expand by roughly an additional 100 basis points over the next few years.