Why Air Products & Chemicals Deserves a Place in Your Portfolio (NYSE:APD)

Introduction

On August 30th I wrote an article entitled “Dividend kings are overrated.” In that article, I explained that while dividend consistency is a great thing, dividend stocks should never be selected based on the Dividend Aristocrat. or Dividend King status.

That said, there are plenty of good dividend aristocrats in the market that are still capable of achieving high growth. One of them is Air and chemical products (New York Stock Exchange:APD).

I was “lucky” to predict the bottom on February 6, when I gave the stock a Strong buy rating after a rather nasty sell-off. Since then, the stock has returned nearly 30%, more than double the S&P 500's 14% return.

My most recent article about this company was published on May 1st, when I called it “The perfect combination of 3% revenue, growth and great valuation.” Since then, it has returned 20%. Over the past 10 years, APD stock has lagged the S&P 500, largely due to post-pandemic issues.

So, in light of recent successes, it appears the company is back on track.

As we will discuss in this article, Air Products & Chemicals is doing well. Despite the challenges, the company is growing its EBITDA, is optimistic about its earnings per share outlook, rewards shareholders with consistent dividend growth, and benefits from new partnerships.

So, let's keep this introduction short and get straight to the point!

The return of growth

With more than 40 consecutive annual dividend increases, Air Products & Chemicals is a dividend aristocrat. However, it is more than that. The $62 billion market cap company is the world’s largest hydrogen supplier, owner/operator of more than 750 production facilities in approximately 50 countries, and a company serving more than 30 industries, making it a mission-critical company in the global chemicals supply chain.

However, the global chemical industry is currently suffering somewhat from weak global growth. While certain cyclical areas are performing well thanks to new growth drivers such as automation, artificial intelligence and economic reshoring to North America, indicators such as the ISM manufacturing index point to very weak demand in cyclical industries.

As we can see below, the moment the ISM manufacturing index peaked, APD’s stock price lost momentum.

The good news is that APD's finances are looking better and better.

Last month, the company released its third quarter results for its fiscal year 2024. These numbers were quite optimistic, as the company reported 5% higher EBITDA at $1.3 billion, driven by higher margins and a favorable business mix, meaning that pricing offset some weakness in volumes (see below).

As a result, adjusted earnings per share increased to $3.29, a year-over-year increase of 7%.

Looking more closely at its regional performance, in the Americas, EBITDA increased by 6%, supported by a 400 basis point increase in EBITDA margins. This was supported by both stable pricing and volumes.

In Europe, EBITDA increased by 12% and margins increased by 500 basis points, mainly due to new assets in Uzbekistan and lower energy costs.

Both Asia and the Middle East/India suffered difficulties due to weak volumes, pricing barriers and planned maintenance.

So far, so good.

What matters is that the company is succeeding in its growth and profitability projects, which bodes well for shareholders.

APD shareholders have a bright future

In its earnings presentation, the company announced an agreement with TotalEnergies (TTE). Starting in 2030, Air Products will supply 70,000 tons of green hydrogen per year.

This agreement supports the company's long-term growth strategy and demonstrates the high demand for green hydrogen, especially in markets such as Europe.

The company also sold its LNG processing technology and equipment business to Honeywell (HON). The deal was valued at $1.8 billion and allowed APD to focus on its core business, which includes a collaboration with Mercedes-Benz to develop fuel cell trucks and build a network of commercial hydrogen fueling stations.

Furthermore, the company continues to demonstrate its operational excellence, with an EBITDA margin of 42%, the highest in its industry.

Even better is the fact that margins are just 30 basis points away from their 2020 all-time high, which has restored a lot of confidence after the company struggled to maintain its margins in 2021 and 2022.

Looking ahead, the company will continue to pursue its “two-pillar” strategy.

This strategy is what sets it apart from smaller startups in the chemical space with far more operational risks, as its two pillars are built on expanding its core industrial gases business (the first pillar) while leading the delivery of low-carbon hydrogen on an ever-larger scale (the second pillar).

In essence, the dual approach supports its financial growth and also makes it a leader in emerging technologies without high financial risks, as it has a huge core business to fund growth. Startups that rely on external funding do not have that benefit.

Based on investments, the company has a return on capital employed (“ROCE”) of 11%. Excluding cash, that figure is 12%.

In addition, it enjoys an A-rated balance sheet with a net leverage ratio of less than 3x EBITDA.

On an annual basis, the company expects earnings per share (EPS) of between $12.20 and $12.50, which implies growth of 6% to 9% and would extend the company's growth streak, which has a compound annual growth rate (CAGR) of 11% since 2014 (!).

This is fantastic news for shareholders.

• APD has increased its dividend for 41 consecutive years. This obviously includes the Great Financial Crisis, the global manufacturing crisis of 2015/2016, the pandemic and the difficult post-pandemic years.
• Despite its age and long history of dividend growth, it has grown 9% annually since 2014.
• APD currently yields 2.5% with a payout ratio of 58%.

The rating is not bad either.

Valuation

Despite its recent rally, APD stock is still far from its highs, which makes sense as the operating environment remains challenging.

However, this also bodes well for valuation, as the company is one of the few stocks on the market that is not trading much above its average multiple.

Using the data in the chart below, APD is trading at a combined price-earnings ratio of 22.7x, which is slightly below its 10-year average of 22.9x.

Using FactSet data in the chart above, analysts expect EPS growth of 7% in 2024, followed by 9% growth in 2025 and 2026, respectively.

This implies a fair share price of $336, 20% above its current price.

While a floor in leading indicators such as the ISM index will likely be required to enable a sustainable recovery, I believe APD remains in an excellent position to deliver returns in excess of 10% annually going forward, making it an excellent stock for a broad range of dividend investors.

Carry

Air Products & Chemicals is demonstrating its resilience and growth potential despite very difficult market conditions.

The company’s strategic focus on its core industrial gases business and leadership in low-carbon hydrogen is bearing fruit, supported by strong financial performance in the third quarter of 2024, impressive margin recovery and strategic partnerships to drive long-term growth.

Furthermore, with a return on capital employed of 11%, an A-rated balance sheet and consistent dividend growth (41 consecutive years), I believe APD offers a compelling investment case.

Therefore, even after its recent rally, APD's valuation remains attractive, positioning it for sustained capital gains.

Pros and cons

Advantages:

• Strong dividend growth: APD has 41 consecutive years of dividend increases, even during major downturns like the Great Financial Crisis and the pandemic, with an annual growth rate of 9% since 2014.
• Solid finances: The company enjoys an EBITDA margin of 42%, the highest in its sector. It also has an A-rated balance sheet and a net leverage ratio of less than 3 times EBITDA.
• Strategic Growth Approach: APD’s two-pillar strategy of expanding its core gases business and leading in low-carbon hydrogen positions it well for long-term growth without high financial risks.

Cons:

• Challenging market conditions: Weak global growth and cyclical headwinds could weigh on APD's performance in the near term.
• Valuation close to historical averages: While the valuation is not bad, APD's price-to-earnings ratio is close to its 10-year average, which could limit near-term upside unless economic conditions improve. However, if economic conditions improve, I expect analysts to upgrade their long-term earnings per share growth expectations.
• Regional weaknesses: While the Americas and Europe are performing well, Asia and the Middle East/India face volume and pricing challenges that could last until we have a broader economic recovery.