During 2016, Air Products and Chemicals, Inc. (APD, Financial) continued to make substantial progress on its transformation under its CEO Seifi Ghasemi. Management has restructured the company into a decentralized organization with greater accountability while transforming the culture and aligning pay with improvements in regional operating results.
Operating margins continued to improve during the most recent fiscal year, increasing 400 basis points to 23.1% in 2016 (APD’s fiscal year ends September 30th, and this year’s results included the non-core businesses subsequently divested and spun). This significant improvement in operating margins drove a 14% increase in earnings per share, exceeding the high end of the company’s fiscal year guidance despite 3% foreign exchange headwinds.
During the year, Air Products executed spinoff and sale transactions for its non-core electronic materials and performance materials businesses, generating substantial cash proceeds. Following these transactions, the company now has minimal net debt with cash on hand and leverage capacity totaling approximately $5 billion. We expect management to invest this capital wisely in the currently opportunistic acquisition environment for core industrial gas assets. The company has highlighted potential small acquisitions and the purchase of captive assets from customers as two potential sources of opportunity.
In January, Air Products issued fiscal year 2017 first quarter results, which showed 9% growth in earnings per share. The quarterly result announcement included a reduction in fiscal year 2017 guidance originally issued in October. While the company reduced guidance by $0.25, only five cents of this reduction is related to the core industrial gases business with the remainder driven by spin-related accounting adjustments, foreign exchange movements, and lower sales of equipment. Seifi highlighted concerns relating to the current uncertainty resulting from the new U.S. administration, Brexit, and upcoming European elections as the cause for his reduced outlook for the core industrial gas business. Notably, Seifi emphasized that the company has not seen any particular weakness in its business, but is simply taking a cautious tone on guidance given the current uncertainty.
If Seifi’s caution about the economy turns out to be conservative and in fact, the new administration contributes to economic growth with successful initiatives in corporate tax reform, infrastructure spending and deregulation, Air Products should be a big beneficiary. While our investment thesis is not predicated on improvements in economic growth, any improvements in growth from recently weak levels should improve Air Products’ organic volume and pricing trends in its merchant business.
Air Products’ revised fiscal year 2017 EPS guidance of $6.00 to $6.25 represents growth of 6% to 11% over the prior year. The guidance is principally driven by continued operating productivity and returns on growth capex and assumes continued economic weakness. Seifi has emphasized that the guidance for the fiscal year does not include any use of the company’s excess capital. As such, this earnings estimate meaningfully understates the company’s true underlying earnings power. We also believe that GAAP earnings understate the true economic earnings of the company as we believe the company’s core assets are longer-lived than the periods over which they are depreciated.
We believe the upside in APD remains significant. APD’s business is extremely high-quality, reasonably priced and run by outstanding management.
Air Products’ total shareholder return (7), including dividends and the spinoff of Versum, was 24.0% in 2016.
From 2016 annual letter to shareholders of Pershing Square by Bill Ackman (Trades, Portfolio).
