I’ve been a little busier this month than I planned on, which is certainly not a bad thing.
After the return to the car-free lifestyle, my available investment capital has been a bit higher than I anticipated even just a month or so ago. And since I favor cash flow over cash to a substantial degree, I’ve decided once more to turn the latter into the former.
There isn’t a plethora of value out there as it pertains to high-quality dividend growth stocks, but I also don’t think that it’s impossible to find great stocks trading at a fair or better price. As such, I picked up shares in another wonderful business whose stock seems to be priced correctly relative to its value. This specific company is a new holding, but I feel great about being a long-term business partner here. This is a stock that I recently listed as one I was watching, so I decided to finally move it from the watch list to the portfolio.
I purchased 10 shares of Praxair, Inc. (PX) on 3/27/15 for $120.06 per share.
Overview
Praxair, Inc. produces, distributes, and sells atmospheric and process gases, as well as surface coatings, worldwide. Their product offerings include oxygen, helium, and nitrogen.
Though it was founded in 1907, it didn’t become a publicly traded company until 1992.
The company operates in five segments: North America (52% of fiscal year 2014 sales), South America (16%), Europe (13%), Asia (13%), and Surface Technologies (6%).
They offer three primary distribution methods: Merchant (34% of FY 2014 sales), On-site (29%), and Packaged Gases (28%).
They are the largest industrial gases company in North and South America and one of the largest in the world.
Fundamentals
Praxair is one of those boring businesses that just routinely grows sales and profit almost like clockwork, year in and year out. Boring is indeed beautiful. It’s been said that successful investing is a lot like watching the grass grow. In that respect, you better get your lawnmower out.
Revenue was $7.656 billion in fiscal year 2005. The company grew that to $12.273 billion in FY 2014. That’s a compound annual growth rate of 5.38% over the last decade.
Meanwhile, PX increased earnings per share from $2.20 to $5.73 over this period, which is a CAGR of11.22%. The bottom line has been boosted by improving margins and a steady reduction of the share count. This result is especially impressive considering the recent currency headwinds – Venezuela currency devaluation negatively impacted EPS by 45 cents in the fourth quarter of fiscal year 2014 alone.
S&P Capital IQ is calling for 9% compound annual growth in EPS over the next three years, which seems reasonable based on management’s EPS guidance of $6.15 to $6.50 for FY 2015.
So as a dividend growth investor, a primary consideration for me is how a company rewards its shareholders via a dividend and how it grows that payout. In this respect, the company doesn’t disappoint.
PX has a wonderful track record as far as paying and growing a dividend, basically stretching all the way back to becoming a public company.
They’ve increased their dividend for the past 22 consecutive years.
And the growth of the dividend itself is quite generous, with a 10-year dividend growth rate of 15.8%.
Now, that growth rate is higher than what the company has managed for underlying EPS over that time frame, but the payout ratio is still moderate at 49.6%.
The stock currently yields 2.38%. Not quite as high as I generally look for, but this is far above the five-year average yield of 1.9%.
Praxair’s balance sheet is leveraged, though not uncommonly so for the industry. The long-term debt/equity ratio is 1.54 and the interest coverage ratio is north of 14. These numbers compare pretty well to competitors.
However, their profitability doesn’t just compare well, it pretty much blows away everyone else. The company has posted net margin that’s averaged 14.14% over the last five years with an average return on equity of 27.26%.
Another aspect to consider about the company is that they’re diversified not only geographically, but also across end markets. No one market accounts for more than 24% of sales, and the company has an array of markets its exposed to, including: manufacturing, marketing, energy, chemicals, healthcare, food & beverage, electronics, and aerospace.
Qualitative Aspects
Companies in a variety of markets require a steady and reliable supply of industrial gases for production processes. And because of the vital importance of these gases and the low cost structure, Praxair is generally able to enter into long-term contracts with clients which provides long-term business visibility.
Their three distribution methods vary a bit, however.
The on-site method is particularly attractive. This allows Praxair to sign a long-term (10 to 20 years) contract with a large client, whereby Praxair builds a plant on or adjacent to its client’s sites and supplies product directly. These contracts aren’t only long term in nature, but also typically include minimum purchase requirements and cost escalations that allow Praxair to index certain input costs like electricity and natural gas to inflation. In addition, Praxair uses any excess supply to provide for a local market on the merchant side as well. This creates an incredible economic moat for Praxair, essentially monopolizing one local market at a time. Furthermore, it creates fantastic visibility for future revenue, assuming Praxair can maintain efficiency over the duration of its contracts.
The merchant method generally involves Praxair delivering product by tanker trucks to clients’ storage facilities. As previously mentioned, Praxair is often able to use its on-site facilities to use excess supply for merchant deliveries, which works well for the company so as to limit distribution costs. This method also typically involves long-term contracts (ranging from 5-15 years). So the vast majority of PX’s business involves long-term contracts.
Packaged gases involves clients who usually require small volumes. Praxair provides gases via cylinders under medium to high pressure. These cylinders may be delivered, or clients can pick them up from a packaging facility or retail store.
Praxair differentiates itself through its superior financial performance, with industry-leading margins and returns. This operational excellence appears to be a result of responsible use of capital and the company’s commitment to building network density. In addition, Praxair is more of a pure play on gases, as the company focuses much less on outside operations like equipment sales or electronics.
The company seems primed for growth, in my view. As of December 31, 2014, the company had a backlog of 24 large projects under construction. And these projects are fairly spread out across the company’s geographical segments, with approximately one-third of the backlog represented by North America and the other one-third represented by Asia. While the company is already dominant in North and South America with network density and long-term contracts, there is also a lot of growth potential abroad.
Lastly, the industry that Praxair operates in is largely consolidated with only a few major global players. This limits competition and creates a favorable and rational pricing environment.
Risks
Praxair’s primary risks involve execution, in my opinion. Though they are diversified across markets and geographies, the company is still largely exposed to the North and South American economies. The company’s ability to replicate its density and operations abroad will be critical to its future viability and growth. In addition, there are currently currency headwinds that are negatively affecting the company, which isn’t unlike most global companies right now. However, over the very long term, these headwinds will likely abate and possibly even reverse.
Praxair’s results can also be cyclical due to its exposure to manufacturing, though its performance over the last decade has been surprisingly secular. This appears to be a testament to its business model and the value of long-term contracts.
Valuation
PX trades hands for a P/E ratio of 20.97 right now, which is more or less in line with the broader market and the five-year average for PX. Overall, PX seems like neither an expensive nor a cheap stock right now looking at that.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7.5% long-term growth rate. This rate is on the higher end of what I usually use, but it seems fair here considering PX’s track record for EPS and dividend growth over the last decade. In addition, the company just announced a 10% dividend raise at the end of January. The DDM analysis gives me a fair value of $122.98.
So it looks like this is a stock that’s priced fairly here. But this could be a great opportunity when looking at the growth potential, backlog of projects, and currency headwinds that will abate at some point.
Conclusion
Praxair has a really attractive business model, providing a necessary product to a variety of industries across the globe. Their clients are willing to sign long-term contracts in order to ensure a constant supply of product, which allows PX to lock down a local market and piggyback other operations onto its on-site distribution. And as overseas markets continue to grow their economies, manufacturing capabilities/demands, and middle classes, Praxair should continue to grow in kind.
This stock should complement my holding in Air Products & Chemicals, Inc. (APD) nicely. Praxair concentrates much more on gases as a pure play. Meanwhile its fundamentals are mostly superior and its valuation substantially lower. APD’s stock has run up incredibly over the last few years, but the valuation seems unwarranted here with a P/E ratio north of 32. APD’s recent stock performance is less due to fundamental business improvement and more due to a P/E ratio expansion. Meanwhile, PX has largely been ignored, leaving what I see as an opportunity in its wake.
I still have a couple of free trades in my Scottrade account, so this purchase involved no commission fee.
This purchase adds $28.60 to my annual dividend income, based on the current quarterly dividend of $0.715 per share.
I’m going to include current valuation opinions from other analysts below, which I use to concentrate my reasonable valuation estimate:
Morningstar rates PX as a 3/5 star value, with a fair value estimate of $125.00.
S&P Capital IQ rates PX as a 4/5 star Buy, with a fair value calculation of $130.60.
I’ll update my Freedom Fund in early April to reflect this recent purchase.
Full Disclosure: Long PX and APD.
What do you think of PX? Like the fundamentals and business model? What about the valuation?
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