These Highly Profitable Companies May Not be Good Investments

Value investors such as Warren Buffett know all-too-well the merits of buying stocks at reasonable prices. Diligently making sure you don't over-pay for a company, even a well-run one, goes a long way in protecting your portfolio against stock price declines. While rising stock markets may tempt investors to throw caution to the wind, keeping downside risk in mind is usually a worthwhile pursuit.

That's why investors interested in the major atmospheric and specialty gas producers, such as Air Products and Chemicals (NYSE: APD  ) , Airgas (NYSE: ARG  ) , and Praxair (NYSE: PX  ) , may want to look elsewhere for cheap stocks. While each stock had a rip-roaring 2013 in terms of share price performance, underlying growth is leaving a lot to be desired. That may set investors up for disappointing future returns.

Less growth than meets the eye
Despite their rising stock prices over the past year, a deeper analysis of each business reveals more modest growth that may not deserve the industry's high valuation multiples. Earnings growth across the specialty gases industry is fueled largely by acquisitions and cost cuts, rather than sustained revenue growth.

For example, Air Products grew revenue by just 6% in fiscal 2013, a full 5% of which was achieved by acquisitions. In addition, diluted earnings per share grew just 2% in fiscal 2013. If you judge the company's performance solely by its stock price, though, you'd be lured into an entirely different conclusion. Shares of Air Products soared approximately 30% last year, better than the market's performance. Unfortunately, organic revenue growth is still hard to come by, which may be a potential red-flag.

Revenue is still being constrained across the industry due to poor sales volumes. This is especially true for Airgas, which is halfway through its own fiscal year. Management made a specific point to note the challenging volume environment in its last quarterly report, especially since the previous quarter occurred during a traditionally strong season for volumes. Not surprisingly, then, Airgas produced just 3% sales growth and 10% earnings-per-share growth, driven mainly by cost reductions. Weakness in volumes is the primary culprit for the company's modest outlook, which calls for just single-digit revenue growth for the full fiscal year.

Praxair holds a similarly cautious view, projecting just 3% earnings growth for the full fiscal year. It does not expect much, if any, volume growth in North America and Europe. This would actually represent improvement over its results so far, which produced just 1% diluted earnings growth over the first nine months of the year.

Is the wild optimism misplaced?
It's likely that a large portion of the broad optimism over these companies was due to noted activist investor Bill Ackman taking a sizable stake in Air Products last year. In all, Ackman's Pershing Square fund took a nearly 10% stake in the company, after purchasing over 10 million shares of Air Products last year.

This seemed to set off a wave of hopes for the specialty gas industry as a whole, that perhaps additional activist investors would step in and persuade management teams to take actions designed to unlock value for shareholders. This has not happened, though, leaving potential investors with slow-growing businesses trading for premium valuations.

Air Products, Praxair, and Airgas each trade for 23-25 times trailing earnings multiples, significantly above the valuation of the overall market. Earnings growth for the S&P 500 is projected to be stronger than the respective outlook for each of the specialty gas companies, yet the market holds a trailing multiple only in the high teens.

The market is clearly pricing in better days ahead for the specialty gas makers, which of course may materialize. However, such confidence is not reflected in their own near-term outlooks. Air Products, Praxair, and Airgas are each solidly profitable companies that pay reliable dividends to shareholders, but the risk-reward proposition may not be suitable for value investors to jump in at current levels.

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