I don't mind owning cyclicals as long as the cycles aren't so vicious that they threaten the dividend, and the dividend grows even in tough times. This stock qualifies on both counts, and looks like a bargain, too.
Air Products & Chemicals
(NYSE:APD) is the third-best performer in the very profitable industrial gas industry, and its results lagged competitors' during the previous cycle.
Although it represents a tiny portion of a customer's cost structure, a reliable supply of industrial gas is vitally important in many production processes. As a result, major customers are willing to sign long-term contracts (15 to 20 years) that permit industrial gas producers like Air Products to index the main input costs for inflation.
This lucrative structure has helped protect operating margins historically, and we anticipate it will continue to preserve the company's profit margins and returns on invested capital, especially if an inflationary environment ensues.
The firm has shed some underperforming businesses, including health care and polymers, which should drive better operating margins and returns on capital. Still, the company has outsize exposure to electronics and hydrogen, two structurally weaker end markets.
The good news is that increasing operating costs have forced nearly 80% of domestic refiners to outsource their hydrogen production needs — hydrogen being a field where Air Products holds a commanding lead. Growth should continue, especially as foreign refiners begin to adopt this outsourcing model. The firm also participates in a plethora of less cyclical end markets, including medical and food and beverage.
Although the firm is capital-intensive — capital spending has averaged 12% of revenue in the past decade — and subject to cyclical fluctuations, my firm believes Air Products is in strong financial health.
Debt is typically in the range of twice annual EBITDA, and has grown roughly in line with cash flow. Our credit rating of A- reflects Air Products' strong competitive position and healthy cash flow.
We're also comfortable with a dividend payout ratio around 50%, given that the largest annual drop in earnings per share in the last 25 years was the 18% decline in 2009.
Like Emerson Electric
(NYSE:EMR), Air Products boasts an impressive record of dividend growth for a cyclical. In March, the company raised its dividend for a 31st consecutive year.
While the pace of dividend growth varies with economic conditions, the overall record is highly favorable: compound average annual growth of 10% over the past five years, 11.9% over the past ten, and 11.0% over the past 30 years.
In the past five years, most of this growth can be traced to an upward drift in the payout ratio (34% to 50%), and this will probably keep future dividend increases closer to the growth in earnings per share.
That said, we expect Air Products to go on increasing its EPS at about 8% a year over the long run, driven primarily by a 7% trend of revenue growth. We also see modest gains in operating margins thanks to cost-reduction efforts.
At a recent price of $91, Air Products offers a current yield of 3.1%, which compares nicely with a median yield of just 2% since 1993. Though near-term results will be affected by a sluggish global economy, we expect future dividend growth will lead to long-term total returns averaging 10% to 11% per year.
Editor's Note: This article was written by Josh Peters of Morningstar DividendInvestor.
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No positions in stocks mentioned.
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