Senator Investment Group's Thesis on Air Products & Chemicals (Q4 Letter) ~ market folly

Thursday, February 6, 2014

Senator Investment Group's Thesis on Air Products & Chemicals (Q4 Letter)

Alex Klabin and Doug Silverman's hedge fund Senator Investment Group has built a sizable position in Air Products & Chemicals (APD) in the fourth quarter, according to their Q4 letter.

We've previously highlighted how Bill Ackman's Pershing Square is long APD and now Senator has bought a stake as well.

Senator's Air Products & Chemicals Thesis

The hedge fund likes that the company is involved in an attractive business with significant barriers to entry and oligopoly-like qualities.  There's 5 suppliers of industrial gasses: APD, Praxair, Linde and Air Liquide, and Airgas.  

Senator writes,

"Air Products trades at 18.1x 2014 earnings, but only 12.7x recurring free cash flow, a more relevant metric given the stable, cash generative nature of the business.  Moreover, for the last few years, Air Products' earnings and cash flow potential have been depressed by large investments in growth projects that have yet to impact financial results."

They like that industrial gas businesses see the majority of their revenues linked to long-term contracts.

Senator notes Pershing's involvement as a positive as the company has ousted the CEO and added new directors to the board.  Senator thinks a new CEO could potentially be announced during the first quarter and will put in place a restructuring plan. 

They feel the company's cost cutting opportunity to be around $400 million or so ("5% of its cost base and 27% of trailing EBIT of $1.5 billion") and point to how competitor Praxair went through something similar in 2000.  The hedge fund's base case for Air Products assumes that a new CEO can capture half of that opportunity.

Senator believes the company could also reap the benefits of the capital investments they made in the past few years as plants come online.  They see $175 million of incremental EBIT from this by 2016, as well as $450 million of increment EBIT opportunity from 'unutilized' merchant gas sales.  Senator estimates earnings growth of 20% in both 2015/16.

Senator concludes,

"A new CEO, a focused board and a large, constructive shareholder will very likely bring about other value maximizing moves, such as the sale, spin or MLP conversion of Air Products' hydrogen pipelines and additional cash returns to shareholders through issuances of project-level debt. In terms of downside, we think the 2014 guidance from the current management is reasonable and translates into $8.70 of free cash flow per share.  In our view, it's hard to envision the shares trading for less than 11x FCF (or 10% downside from current levels) given the defensive characteristics of the business and the imminent announcement of a new CEO.  Over the next two years, we believe Air Products' shares could trade to 15x our $12 free cash flow estimate or $180 per share, implying close to 70% upside in a large cap, high-quality business."

For more on this hedge fund, we've posted some of Senator's other recent portfolio activity here.

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