Ballooning Returns or a Bunch of Hot Air?

The manufacturing sector expanded in July for the second straight month, with the Purchasing Managers Index -- a gauge on manufacturing activity -- rising 4.5% from June levels to 55.4. Some argue the U.S. is on the cusp of a manufacturing renaissance, one that could rival pre-recession levels. Nonetheless, millions of manufacturing jobs have been lost in the past decade, and according to Bloomberg , the recovery in manufacturing has been painfully slow. 

Industrial companies that cater to the manufacturing sector are seeing signs of progress -- but has that growth stalled? To find out, let's look specifically at companies that produce packaged gasses such as helium, hydrogen and nitrogen for major sectors of the economy, including energy, health care, food and retail, and construction. 

A domestic play

Airgas (NYSE: ARG  )  has a 25% market share in the $13 billion U.S. packaged gasses and welding-equipment market.  At a recent industrial conference hosted by Jefferies, Airgas chief executive Michael Molinini offered his industry outlook.

While manufacturing conditions are on the upswing from the recession that lasted through 2009, the most robust part of that recovery, when businesses were initially coming off the sidelines and beginning to deploy capital, has passed. Now there are pockets of strength, such as the energy sector -- but other areas such as construction still haven't quite returned to pre-recession levels. 

Some 65% of Airgas's revenue comes from the sale of gasses, with the remaining 35% stemming from welding equipment and safety products. Over the next three years, the company expects to grow its sales by about 6% each year, driven by higher volumes and pricing. Airgas saw its free cash flow jump 14% in 2013, and finished its first quarter with $100 million in cash.

But the non-residential construction market, such as offices, manufacturing, and the transportation sector, is holding Airgas back. This area contributes 16% to the company's overall sales. As Molinini explained, there aren't many shovels breaking ground. Worse, 98% of Airgas' revenue is generated in the U.S., and so it's not like the company can look to non-residential construction activity abroad to offset weakness. 

Indeed, last month, the non-residential construction sector slashed nearly 10,000 jobs while residential construction added more than 6,000 new jobs, according to The Wall Street Journal. The divide could be blamed in part to the sequester, as construction budgets have been cut in the public sector . So until this market segment picks up and announced projects materialize, non-residential construction will continue to be a drag on Airgas' revenue performance. 

Bitter rival

Air Products & Chemicals (NYSE: APD  ) is a much larger competitor to Airgas, with nearly double the revenue. Yet Air Products' gross margins are more than 50% lower than Airgas's, which suggests that a smaller proportion of its sales ($9.1 billion in 2012, down 1% year-over-year) is reaching the bottom line.

The company is well aware of this, and blames slow global manufacturing growth for its recent performance. In its latest quarterly earnings report, Air Products' chairman and chief executive John McGlade stated: "...We are actively assessing additional actions that we can take that would result in increased value to our shareholders. While our review continues, we have already identified further actions we expect to take to improve margins and returns."

Activist investor Bill Ackman already muscled his way into the company, taking a 9.8% stake only weeks ago. Air Products had caught wind of Ackman's plans; it implemented a poison pill to prevent Ackman from taking a 10% position in the company, and ultimately taking over Air Products.  

Incidentally, Airgas resorted to a poison pill a couple of years back, when larger rival Air Products was attempting a hostile bid. Airgas' maneuvers worked, and now Air Products -- which has become the target of shareholder activism -- has a year before its own defensive move expires.  

In the company's most recent earnings report, McGlade characterized his outlook for the rest of the year as "tempered" and blamed "modest economic growth." On the bright side, Air Products has a project backlog of some $3 billion. It expects that when these projects come online, they will quickly be accretive to earnings and cash flow. 

Geographic diversity

Industrial-gasses company Praxair (NYSE: PX  ) serves some of the same end markets as Airgas and Air Products, such as chemicals, energy, and manufacturing. Its business is spread across the globe -- which actually hurt Praxair in 2012, amid weak economic conditions and the impact of a strong U.S. dollar versus other currencies. In North America, it grew organic sales and profits at 5% and 10%, respectively, in 2012.  

Praxair is also being hurt by the slowdown in the non-residential construction industry, which weakens demand for packaged-gas. Praxair is looking to strength in its energy and chemicals segments to offset the weakened demand for packaged gas. About 50% of the company's project backlog is from customers in chemicals, energy, and electronics end markets across Brazil, Russia, India, China and Korea. 

Praxair generated $577 million in free cash flow in its second quarter, during which time it paid $177 million in dividends and bought back $152 million in stock. The company's geographic diversity is attractive, and it continues to invest in new equipment for production plants that command long-term contracts with the markets the company serves. 

Conclusion

Airgas, Air Products and Praxair trade at relatively similar forward price-to-earnings ratios of 20.4, 18.9 and 20.1. In an industry still recovering from the depths of the recession, I believe Praxair is the best positioned at the moment, despite its slightly higher valuation. It's too soon to tell whether Air Products' shareholder-activism mess, could eventually unlock value. And while Airgas is a bet on U.S. industrial activity, I just think it has more of an uphill climb than Praxair.


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