Making Money out of Air

07/23/2009 1:00 pm EST

Focus: STOCKS

James Stack

President, Stack Financial Management

James Stack, president of Stack Financial Management and InvesTech Research, likes a leader in a key industry that is growing nicely and is in great financial shape.

Any company that creates over $10 billion a year in sales … from air (actually industrial gases) is worth a look.

For Air Products and Chemicals (NYSE: APD), much of that “air” revenue comes from the sale of tonnage gases, [which] involves the on-site or pipeline delivery of hydrogen and other chemicals to oil refineries.

Hydrogen is a key component in reducing sulfur content during the refining process, making hydrogen plants adjacent to refineries indispensible to world gasoline supply. APD [has] nearly 40% market share of global hydrogen capacity–nearly twice that of its nearest competitor.

APD has leveraged [that edge] into worldwide leadership in various industries dependent on chemical inputs. Although tonnage gases are a key revenue driver for APD, the energy sector itself accounted for only 24% of the firm’s 2008 revenue. Other diverse sectors, including industrials, medical, electronics, and food, all rely on APD’s industrial gases and chemicals.

Despite end-user diversification, the current recession has effectively knocked the air out of APD, [but] it has also prompted management to intensify productivity efforts, cut costs, and realign for future growth. It is also providing investors an opportunity to invest in a quality company at prices 30% below the 2008 high. (It closed below $70 Wednesday—Editor.)

APD benefits from the world’s declining supply of “sweet” crude oil. It is almost universally agreed that the easy oil has been found. Most of what is left is likely heavier, less pure crude oil that requires roughly three times the amount of hydrogen to process per barrel.

APD is also positioned to benefit from further exploration and growth in the Canadian oil sands, an oil field many estimate to be [as big as] Saudi Arabia’s reserves. APD has the only major hydrogen pipeline into the region—a significant advantage over competitors.

Standing behind APD’s growth potential is significant financial strength. In addition to great liquidity and a manageable debt load, APD’s return on equity has never dipped below 12% in the past 20 years—an impressive feat for a cyclical materials company. Such earnings consistency has allowed APD to increase its dividend in every one of the past 27 years.

Along with growth potential and financial strength, APD completes the investment trifecta with an attractive valuation. Although all of the major valuation metrics show APD as undervalued historically, the most interesting analysis may come from the dividend yield. At a current 2.6% dividend yield, APD’s market price would need to increase 25% to bring the yield back to the 20-year mean of 2.1%.

Bottom line: APD is an industry leader with significant growth potential. With the macroeconomic wind at its back, management can continue to position APD to capitalize on opportunities while investors can capitalize on depressed valuations as a great entry point. We continue to recommend APD as a “Buy.”

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