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Buffett-Munger Highlight Weekly Report - Praxair Corporation (PX)

April 11, 2011 | About:
Praxair Inc. (PX) is an industrial gas supplier in North and South America. Praxair’s primary products for its industrial gases business are atmospheric gases (oxygen, nitrogen, argon, rare gases) and process gases (carbon dioxide, helium, hydrogen, electronic gases, specialty gases, acetylene). The Company also designs, engineers and builds equipment that produces industrial gases for internal use and external sale. The Company’s surface technologies segment, operated through Praxair Surface Technologies, Inc. Praxair serves approximately 25 industries, such as healthcare and petroleum refining; computer-chip manufacturing and beverage carbonation; fiber-optics and steel making; and aerospace, chemicals and water treatment. During the year ended December 31, 2010, 94% of revenue was generated in four geographic segments (North America, Europe, South America and Asia). As of December 31, 2010, Praxair had acquired a 49% interest in Refrigeration and Oxygen Company Limited.

Analysis:

Praxair is one of the world’s leading industrial companies. The company operates within the industrial gases category which is a high-growth, high-return industry. It is characterized by a unique combination of attributes: it is a genuine oligopoly with four large public companies dominating global markets, economies of scale provide barriers to entry, there are few local competitors in emerging markets, the industry has structural as well as cyclical growth drivers while stable pricing and long-term contracts lead to high margins.

Due to its size and scale, it has few competitors. Praxair is one of four listed global industrial gas suppliers, the others being Air Liquid, Air Products and Lined. Praxair is the leading supplier in North and South America and has the highest emerging markets exposure. Primary products are atmospheric gases (oxygen, nitrogen, argon) and process gases (including carbon dioxide, hydrogen and carbon monoxide) which are supplied to a wide range of industrial customers, including steel, petrochemicals, refining, electronics and general manufacturing. The smaller Surface Technologies division supplies corrosion-resistant metallic and ceramic coatings and powders to the aerospace, chemicals and metals sectors.

Praxair is considered to be a cyclical industrial play, although the company’s results demonstrate the ability to grow over the long term. As with most cyclical plays, timing becomes more important. The company has outperformed most peers in the specialty chemical segment which has been relatively out of favor. Industrial gases are earnings driven stocks with EPS momentum driving most of the stock price performance and this is true for Praxair as well. This tends to parallel economic growth. However, given the company’s scale and market dominance, they will be more immune than competitors. The industry has experienced accelerated capital investment which should lead to sustained future growth. This combined with the global recovery could be a significant catalyst.

Currently, there are some positive and potentially negative developments. Industry pricing power is strong, due to high barriers to entry, placid competitive landscape, limited substitutes and long-term pass-through contracts. Sales backlog of new project remains quite robust. However, there is some evidence that Praxair’s competitors are gaining market share in high-growth regions like India and China. This could result in competitive bidding for new projects with lower return on investment. It will be key for Praxair to remain disciplined in the pricing of new projects. The $2.5 billion project pipeline is estimated to occur within the next two years.

As is true for all industrials, earnings momentum is a key driver for share gains. Given the inherent capital intensity of the industry, earnings growth through the cycle is largely a function of capital investment levels and capital returns. Praxair has established certain competitive advantages: 1) Praxair has the highest level of exposure to emerging markets and hence faces the highest rates of underlying market growth. 2) Praxair’s market share density in each of its core markets - number 1 in 80% of its business, balanced exposure to end-customers and favorable mix of distribution channels are key drivers. 3) Market positions provide unrivalled potential for new capital investment. It is estimated that Praxair has won a major share of new contracts in the US and a significant share of business in emerging markets. Praxair has been cautious with new investment in Europe, however.

Emerging markets offer big potential for an industrial such as Praxair. The big consumers of industrial gases are the steel, chemicals and refining industries, to which Praxair has a well-balanced global exposure. While mature in the developed economies, these industries are booming in the emerging markets, providing significant potential upside for the major industrial gases companies. While the opportunity is large, the local competition is limited providing even greater confidence for Praxair. Projects in emerging economies such as Brazil may become quite significant.

The hydrogen business is large and growing. The chemical process treatment of crude oil has been the major driver of global hydrogen demand as legislation in both the US and Europe has required lower-sulfur diesel. This trend is more established in the developed world; however, the hydrogen segment is poised to grow by 60% over the next ten years. Heavier crudes found in the Canadian Oil Sands, Central America, Russia and the Middle East require more hydrogen and refining capacity is still growing in these developing economies. In addition, while the sulfur content of gasoline is only limited in North America, Australia and Europe, additional legislation is still pending, such as low-sulfur diesel for rail-roads in 2012 and Marpol for ships in 2015. Moreover, this trend has still to play out in India and China, while Latin America and Africa also continue to use very high sulfur content diesel. Praxair has a smaller hydrogen business than the other three global gases companies but it is growing at 15% per annum.

Finally, PX has a market leading position in China. Praxair’s Asian business is smaller than its three peers and lacks meaningful exposure to the large but more mature Japanese market. Praxair’s presence in the faster-growing economies of China, India, Thailand and Korea is potentially more significant.

Current geographic breakdown:

North America

Sales rose 11% driven by volumes up 9%, a cost pass-thru of 1% and FX up 1%. The electronics, chemicals, energy and manufacturing markets showed the most robust volume growth. Merchant sales were up 13% with better pricing, improving volumes from the Canadian business and capacity utilization increasing to 80%. Packaged gas was up 9% and Mexico was up 10% led by autos, glass and steel. Operating margins increased. Margin growth was driven by strong volumes that led to operating leverage.

Europe

Sales were down 3.4% for a 1.9% decline. While volumes were up 4% and cost pass-thru and acquisitions added 1% each, these were all offset by a 9% currency headwind. The volume growth was driven by the chemical and metal markets, on-site and merchant growth in Germany and merchant growth in Southern Europe, although packaged gases was still soft. Operating margins declined in the area. The volume growth was offset by start-up costs associated with new projects in Russia and The Middle East.

South America

Sales were up 11.9%. Volumes were up +9% and pricing was up +2% which were the primary drivers of growth. Demand was driven across distribution types and end markets. The merchant business was up on a sequential basis, while the packaged business was down in line with seasonal trends.

Asia

Sales grew 12.4%. Volumes were strong +16% and cost pass-thru was favorable. Growth was led by new plants and growth in the merchant business in China, India and Korea. Sales growth was strong across end markets, with particular strength in metals, manufacturing, electronics and chemicals. Praxair saw positive trends in their merchant business partially offset by electronics and rare gases. Operating margins increased in this segment. The higher sales volumes and improved mix were the primary drivers of margin expansion. The company expects a strong pipeline in China that continues to grow.

Surface Technologies

Sales rose 6.4%. Sales grew a strong 9%. Aviation coatings were particularly strong, but partially offset by industrial gas turbines as customers slowed their production. Industrial coatings were strong in the U.S., but softening in Europe. New project bookings continue to grow in both China and India.

Valuation:

Ratios – P/E (ttm) 26.6X

P/S 3.1X

P/B 5.4X

EV/EBIT 18.6X

Discounted Cash Flow Analysis –

10 year growth Margin of Safety
>15% 14%
10% -7%
<10% -19%


Financials:

Book Value / Share Return on Equity Return on Assets
Dec 2010 $19.05 20.6% 7.8%
Dec 2009 $17.34 23.6% 8.8%
Dec 2008 $13.06 30.2% 9.3%
Dec 2007 $16.30 22.9% 8.8%
Dec 2006 $14.19 21.7% 8.9%
Dec 2005 $12.11 18.8% 7.0%
Dec 2004 $11.15 19.3% 7.1%
Dec 2003 $9.47 18.9% 7.0%
Dec 2002 $7.21 23.4% 7.4%
Dec 2001 $7.70 17.3% 5.6%


Risk:

- Economic risks

- Competitive pricing issues

- Currency exposure

- Antitrust / Legal issues

Conclusion:

Praxair is an excellent way to play the industrialization the emerging economies. This is potentially a growth story masquerading as a cyclical and while valuation isn’t cheap, the rewards may outstrip the risks.

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Rating: 3.7/5 (13 votes)

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